5 Cognitive Biases And Heuristics That Impact Trading Decisions

by: CrowdThnk

Traders and Investors often take erroneous mental shortcuts in arriving at their decision on an investment, deviating from an objective approach.

Oftentimes, investors can be led astray simply due to the order or manner in which they’ve received information or the circumstances under which they’re making a decision.

Being cognizant and mindful of these biases can ultimately lead to one making an optimal investment judgment.

As the market takes a tumble following announcements of potential reciprocal European Tax Hikes on US Tech Companies and revelations that Facebook (NASDAQ:FB) had released user data without permission, it's an opportune time to take a look at 5 Cognitive Biases and Heuristics that potentially impact one's trading decision. In an effort to be as rational as possible when evaluating objective investment decisions, it's important to understand when emotions and mental shortcuts interfere with one's goals. Being mindful of these biases can ultimately lead to one making an optimal investment judgment. Here's a look at common cognitive biases in markets and how they can impact one's trading decisions:

1. Loss Aversion (Losses Loom Larger than Gains) - Also called Prospect Theory, Loss aversion refers to people's tendency to prefer avoiding losses to acquiring equivalent gains. That is, in trading, the loss of $100 'feels' worse than the gain of $100. Some studies have suggested that losses are twice as powerful, psychologically as gains. In other words, investors are more averse to losing than they are to winning and psychologically speaking, they will avoid incurring a loss versus having the same potential profit if the odds are the same on both sides. For example, if an investor knows with certainty that there is 50% probability of Google (NASDAQ:GOOG) (NASDAQ:GOOGL) going higher by 7% over the next month with an equal probability of the stock selling off 7% over the same time frame, he is most likely not going to invest and will miss a potentially profitable opportunity. Different investors have different risk tolerances and some may even decline to purchase the stock if he knew the odds were skewed 60% to 40% in his favor - typically a trade rational investors would take every time as it is profitable over the long-run. What odds would you need to receive to make that investment decision?

2. Hindsight Bias (Lookback Tendency) - Hindsight bias is the inclination, after an event has occurred, to see the event as having been predictable, despite there having been little or no objective basis for predicting it. In November 2016 before the US elections, most market participants had mentioned that Trump's ascendancy to the President of the United States would be a harbinger to negative stock returns given his relative unpredictable nature. In the moments that followed the confirmation of victory, those fears had been vindicated as US stock markets sold of aggressively. However, that episode was only short-lived as indices quickly rebounded and continued rally over the next year to go on a historic run, reaching all-time highs as the Trump White House passed massive corporate tax cuts. A hindsight bias would have viewed this scenario as predictable even though the facts at hand before election night 2016 weren't so self-evident nor assured.

3. Recency Bias - Recency bias is believing what occurred in the recent past will continue to occur in the future. It is the full belief that what has happened most recently will keep on happening in the future in all likely probability. Over the past year of 2017, market investors have become accustomed to very low volatility with the VIX hitting all-time lows and stocks propelling forward without even a 1% retracement for months on end. This benign investment environment, spurred by fiscal support on the tax side, had given investors full confidence to believe the environment would continue into the new year. The month of January played out according to script with markets going almost parabolic, gaining over 7% in just over 3 weeks - a near-unprecedented event. However, this set the stage for a rude-awakening as investor's recency bias led them to believe the recent past would continue, only to be dumbfounded by an extreme expansion of volatility and over 12% market sell-off within just a couple days. The majority of investors were caught off-guard, having been lured into the Siren Song of low volatility and persistently increasing returns.

4. Anchoring Bias (Relying on First Info) - Anchoring describes the common human tendency to rely too heavily on the first piece of information offered - the "anchor" - when making decisions. In other words, people tend to process information sequentially, basing any future information relative to what's already been received initially. In the trading world, if an investor is analyzing a decision to invest in Apple (NASDAQ:AAPL) and learns that they are releasing a new iPhone with features that should boost the company's profits but then subsequently learns that they're facing patent-infringement lawsuits against a competitor that could cost billions, the investor will more likely weight the first piece of information - Apple's new iPhone release - with a greater emphasis than the second. In this scenario, the investor would more likely purchase the stock than not. However, if another investor learns of the lawsuit first and then the new iPhone release, he will be more likely to put emphasis on the negative news rather than positive news of the iPhone release and ultimately decide not to buy the stock.

5. Confirmation bias - Confirmation bias is seeking out information that supports an initial thesis while disregarding all else. In investing parlance, confirmation bias is akin to analyzing an investment with blinders on, focusing solely on evidence that confirms their hypothesis. For example, if one is analyzing reasons to purchase shares in Facebook and has a confirmation bias to look only for positive signs such as its acquisition of Whatsapp or new advertising verticals, he may completely overlook the fact that user growth in some developing companies has been slowing and even declining in many developed countries. Or the more recent news of Cambridge Analytica siphoning private personal data from over 50 million Facebook users which calls into question the security and integrity of the platform. In order to achieve an objective approach, it's important to be cognizant if you're analyzing opposing rationales for investment and you tend to ignore or overlook data that doesn't confirm your own personal bias. Some of the most renowned traders and investors in history have a penchant for actually looking for disconfirming evidence, seeking to find holes within their investment process.

Summary & Key Takeaways

The investment world is awash in many cognitive biases that can potentially cloud a human's objective judgment, making it more subjective in the process. Oftentimes, investors can be led astray simply due to the order or manner in which they've received information or the circumstances under which they're making a decision. CrowdThnk strives to deliver customers an objective perspective on the Market's Positioning Scores, enabling users to process information using a quantitative approach. In order to focus on a data-oriented, objective approach to investing devoid of cognitive biases that could lead to errors, we advocate the following:

  • Make your decisions with a long-term perspective
  • Admit your mistakes
  • Don't try to predict what's unpredictable
  • Strive to become as rational as possible
  • Be aware and cognizant of your own inclinations

For more information on cognitive biases and how they can impair decision-making abilities, we'd highly recommend the book by renowned behavioral psychologist, Daniel Kahneman, called Thinking Fast and Slow. In the meantime, CrowdThnk will continue to deliver objective and probability-based market insights based on crowdsourced market positioning data, helping you make better-informed investing decisions.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.