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Are you a trader who wants to improve your trading skills and increase profits? Did you know that cognitive biases can have a significant impact on your trading decisions? Cognitive biases are innate thinking errors that occur when people process information, and they prevent us from accurately understanding reality, even when we are given the necessary data and evidence to form a more accurate representation.
Let’s take a look at some of the cognitive biases that traders and investors are susceptible to, and then I’ll tell you what you need to do to limit them.
Tendency to be negative: This bias refers to the tendency to place more weight on negative information than on positive information.
Loss avoidance bias: It refers to the tendency of traders to avoid losses rather than earn an equivalent profit. In other words, the pain of losing is psychologically twice as much as the pleasure you get from profits. And this bias can make traders behave irrationally.
Player error: This bias refers to the belief that future events depend on past events, when in fact they are independent.
Offset confirmation: This bias refers to the tendency to look for information that confirms pre-existing beliefs and ignore information that contradicts them.
Prejudice in hindsight: This bias refers to the tendency to believe that past events were more predictable than they actually were.
Anchor offset: This bias refers to the tendency to rely too heavily on the first piece of information encountered in making decisions.
Footboard effect: This bias refers to the tendency to do or believe what many other people do or believe in the same thing.
Tendency to self-confidence: This bias refers to the tendency to overestimate one’s abilities or the accuracy of one’s beliefs and judgments.
Recent bias: This bias refers to the tendency to give more weight to recent events than to earlier ones.
Prejudice for selfish purposes: This bias refers to the tendency to attribute positive events to one’s own character or actions, and negative events to external factors.
There are many other cognitive biases, but these are just a few that are relevant to the field of trading. They come into the picture and structure how we perceive market information, very often in ways that don’t help us in the long run.
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Why You Can’t Completely Eliminate Prejudice
Cognitive biases are inherent in human thinking and perception, and it’s important to remember that simply being aware of these biases doesn’t necessarily free you from them. As a trader, your trading approach must include mechanisms to limit such biases, otherwise you’ll just shoot yourself in the foot repeatedly and you won’t get anywhere in terms of consistency.
Once again, you can’t just get rid of prejudice. Some people seem to think that you can, but to that I will say this: not seeing your own biases is itself a bias (blind spot bias is the tendency to recognize biases in others without noticing biases in yourself).
Prejudices dull the complexity of the world for us—it’s just the way we see the world and think. They are inevitable. However, they can be softened. For example, it’s helpful to remember that our brains have developed these biases to cope with information overload.
The world is a complex place, and we are constantly being bombarded with all sorts of information flowing to our five senses. The best estimate I’ve read about this is that about 11 million bits of information per second are available to our senses at any given time. research also tells us that our brain has a limited amount of information that it can take in on a conscious level, and this number is about 50 bits per second. That’s a big difference, isn’t it? There are 11 million available, but only 50 will fit…
So, not surprisingly, this means that there is a huge filtering going on in our brain, and this takes the form of habits in the way we perceive and think about things. We constantly filter information and select those that already fit our worldview.
And that is not all. There is uncertainty in this mess of information available to our senses. What I mean? Well, there are many deep and important questions about reality that we don’t know the answers to, and the lack of “knowledge” and uncertainty is confusing; it worries us, so we fill in the gaps with our own stories and match it all up with our existing mental models.
But some of the information we filter out is actually useful and important, so what does the mind do? Well, he fills in the gap with the information he already knows, and sometimes that’s enough, but often not.
In order to act quickly in a world full of all sorts of dangers, our brains must make split-second decisions that can affect our chances of survival. But quick decisions and reactions are often counterproductive because most of the time they are based on short-term emotional gratification. And short-term emotional pleasures often run counter to our long-term goals—what we know rationally is best for us.
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How to Limit the Impact of Cognitive Biases
Now there are ways to limit the effects of cognitive biases and improve your trading results. The key word here is “limit”. Again, biases are an inevitable part of human thinking and perception, and we can only moderate the extent to which they affect our results as traders.
You can use tools such as meditation to become more aware of your innate biases, thoughts, and emotions. I am very proficient in meditation given my experience as a meditation teacher and I have found that it is very effective in helping us develop self-awareness and emotional maturity. Such a thoughtful life also helps us to better understand that we are beings with constant biases and that, despite this, there is room for improvement. We can get better… not perfect, but better.
So, meditation is one way to limit the role of bias in your trading process. Another way is to take a rules-based approach to trading. “If X happens, I will do Y”; “If Y happens, I will do Z.” You don’t need to have hard and fast rules for everything – only for complex decisions where there is a lot of uncertainty and potential risk. Examples of difficult decisions include your position size, stop loss placement, and what you need to do if there is a gap below your stop loss.
Soft rules are usually good for all other easier decisions, such as your profit target or when to trade.
In conclusion, by understanding how cognitive biases can affect your trading decisions, you can develop effective strategies to mitigate their effects and improve your profits. Just keep in mind that our brains have developed these biases to deal with information overload and the complexity of the world. But by combining self-awareness with a rules-based approach to trading, you can make more informed decisions based on objective criteria and increase your chances of trading success.
Related: Trading Psychology 101 – How Traders Can Manage Their Emotions and Succeed