Trading Psychology 101

It was recently suggested that I should write a book on trading psychology. Unfortunately I’m not the right guy. I have street smarts, including sitting on a couch for 6-months talking it through with a therapist, but I’m in no way qualified to write a book. I do see many issues each week that traders face, so let me share some of those cognitive biases with you now:

Confirmation Bias:
This is where we only take in information that agrees with our perspective and disregard all other conflicting information. An example would be a well-known newsletter author who for the last 15-years suggests the Dow Jones will go to 1000.

In-Group Bias:
This is where we specifically surround ourselves with people with similar opinions to ourselves, whether that be about a single stock [What I Learned Losing A Million Dollars], or about a complete investment style – think about the Warren Buffett parrots that make the annual pilgrimage to Omaha to slap each other on the back about value investing.

Gambler’s Fallacy:
This is the belief that if something happens more frequently than normal during a certain period, it will happen less frequently in the future. Trish and I were able to put down the deposit on our first house thanks to someone who fell for this. Even if you throw 14 heads in a row, the chances of the next coin toss is still 50/50.

Anchoring Effect:
This occurs when a small sample of information is used to make subsequent judgments or decisions. A real example came across my desk recently. A new client started trading our Dividend Momentum strategy. The first 4 trades were losses and from that the decision was made to abandon the strategy, even though the last 80 trades have resulted in a net return exceeding 42%.

Dread Risk:
This is the fear of extreme events and can sometimes be associated with In-Group Bias. I knew a gentleman back in 2001 who subscribed to almost every doom and gloom newsletter you could get. He became so obsessed with a stock market collapse and subsequent depression that he was only ever able to invest less than 1% of his SMSF at any time. Needless to say he sat in cash and missed the massive bull market between 2003 and 2007 which, at his age, was a major tactical error.

Read an extensive list of behavioral biases HERE