In this lesson
- recognise the most common thinking traps in trading
- see what research showed about overconfidence
- learn a few simple countermeasures
The emotions from the last lesson can at least be felt. Thinking traps are more treacherous: they feel like sound reasoning. The brain makes its work easier with shortcuts, and in trading those shortcuts cost us money.
Confirmation bias#
When we believe something, we look for information that proves us right and overlook the rest. This is called confirmation bias. You buy Bitcoin and suddenly you only read articles about it going up. Critical news you dismiss as "FUD" (fear, uncertainty and doubt).
Countermeasure: before a trade, write down three reasons why it might not work. If you cannot find any, you did not look.
Overconfidence#
A few successful trades and people think they have figured the market out. Economists Brad Barber and Terrance Odean studied the accounts of 66,465 households from 1991 to 1996. The households that traded the most earned on average 11.4% a year, while the market returned 17.9%. The most active traders did clearly worse than those who did almost nothing – mainly because of trading costs. The authors explain it precisely with overconfidence.
Countermeasure: measure yourself in the journal by the numbers in R, not by feeling. And compare yourself with what simply holding would have returned.
Sunk costs#
"I already have so much money in it, I cannot sell now." The money you lost is gone whatever you do. The only question is: would you buy it today at this price? If not, why are you holding it?
Anchoring on the purchase price#
"I will sell once it gets back to the price I bought at." The market does not care about your purchase price at all. The plan and the stop-loss should decide, not a number in your head.
The gambler's fallacy#
"Five losses in a row, now a win has to come." It does not. Every trade stands on its own. From the lesson on expected value you know long streaks are normal – and they work both ways.
Hindsight bias#
"It was obvious it would fall." In hindsight everything is obvious. At the time it was not – and anyone who tells themselves it was stops learning from their own decisions. That is why the journal records the reasons in advance.
Being smart does not help
These traps affect professionals and even the scientists who write about them. Thinking harder does not help – rules, a checklist and a journal that stop you before you decide do.
Common myths#
- "It does not apply to me, I know about it." Knowing about a trap is not enough to avoid it.
- "So many people cannot be wrong." They can. The crowd often buys at the top.
- "I am right, the market just has not realised it yet." The market always has the last word.
Summary
- Confirmation bias: we only look for what proves us right – write down reasons against.
- Overconfidence leads to frequent trading, and that to worse results.
- Sunk costs and the purchase price are not reasons to hold a position.
- Rules, a checklist and a journal help against traps, not more thinking.