“Trading is hard”, is something we traders know already, but there are proven psychological effects that explain why the human mind is not made for trading. In the following article we will explore seven of the most popular psychological phenomena, what they mean for traders and what to be aware of when you interact with other traders.
In general: The Bandwagon effect describes the phenomenon that the probability of one person adopting a belief increases based on the number of people who hold that belief. This means that if more people share a certain belief, even it is a wrong belief; it is more likely that other people will agree and also accept a group’s ideas and assumptions.
In trading: If you are a member of a trading Skype group, read threads in trading forums or just exchange ideas with other traders, you are more likely to think that trading strategies that are popular and widely discussed must be profitable, even without seeing any sign of proof. It is therefore very important as a trader to be aware of the fact that when you read trading forums or talk to other traders, you never know the other person, their intentions and their abilities.
In general: Herding explains the effect that people tend to flock together, especially in times of uncertainty or when the going gets tough. If you have to face a difficult decision or have to deal with a situation that you cannot explain, you look for other people and mimic their behavior. The rationale is that a group, especially a big group, cannot be wrong or fooled easily.
In trading: There are two negative effects for traders that exist through Herding behavior. First, Herding can be the reason for the creation of financial bubbles. When more and more people talk about a certain investment, everyone tends to believe it is a “sure thing” because “so many people can’t be wrong”. And second, if traders fail to understand the development of a market, they will flock together to come up with certain random explanations or just unanimously agree that “the markets are weird and irrational”. This ignorance and delusion of understanding will lead to further wrong trading decisions and blaming the markets instead of facing one’s own mistakes.
In general: The Information Bias describes the tendency to seek information when it does not change the outcome of a certain situation – more information is not always better.
In trading: The Information Bias plays a very important role in the life of a trader. When traders encounter losses, they believe it is their fault and that there are certain things he doesn’t know, but could prevent him from taking losses next time. Therefore, traders go out and buy books, read in trading forums for days and weeks and watch trading webinars without end with the goal to gather more knowledge about “how the markets and trading works”, whereas in reality, losses don’t occur because a trader knows too little. The Information Bias is, therefore, one of the main reasons for system hopping and the endless quest for the Holy Grail in trading.
In general: The Ostrich effect describes the phenomenon to ignore dangerous or negative information by “burying” one’s head in the sand, like an ostrich. Addict smokers are a good example of the Ostrich effect when they neglect the fact that smoking causes cancer and a variety of diseases – even when faced with horrible photographs on the outside of cigarette packs.
In trading: When traders find themselves in losing trades, but cannot accept that they are wrong, they will turn into ostriches. To try to outsmart the market and maybe turn a losing into a profitable trade, traders will often try to average down, which means adding new positions to losing trades – a recipe for disaster. And another common ostrich-mistake is to widen stop loss orders to delay the closing of the losing position with the hope that markets might turn around in their favor.
In general: The Outcome bias describes the fact that humans judge a decision based on the outcome, rather than how the decision was made. If you win a lot of money gambling all your net worth, it doesn’t mean that it was a smart thing to do.
In trading: The Outcome bias is a very dangerous effect for traders because it can lead to wrong assumptions about how trading works. If a trader abandons his trading plan and takes a random trade based on “gut feeling” or pure guessing, but finds himself in a winning trade, he might believe that he doesn’t need a trading plan and developed some sense about how markets move, whereas in reality, it was pure luck. Therefore, never deviate from your trading plan and always stick to your trading rules.
A ‘bad’ trade can turn into a winning trade and a ‘good’ trade into a loser. In both cases, the outcome is not based on a trader’s abilities, but on the nature of how trading works.
In general: Overconfidence describes the phenomenon that some humans are too confident about their abilities, which causes them to take greater risks in their daily lives. In surveys, 84 percent of Frenchmen estimate that they are above-average lovers (Taleb). Without the overconfidence bias, the figure should be exactly at 50%.
In trading: It doesn’t matter where you listen to traders talking, you will always get the impression that 99% of all traders are chest-pounding millionaires, riding the markets up and down, whereas in reality, less than 1% of all traders can make profits. In a 2006 study, researcher James Montier found that 74% of the 300 professional fund managers surveyed judged their performance as above-average and almost 100% believed that their job performance was average or better.
Self-Enhancing Transmission Bias
In general: The Self-enhancing transmission bias explains the effect that everyone prefers to talk about success more than about failures. This leads to a false perception of reality and inability to accurately assess situations. Although it is obvious most people are no high achievers like Tiger Woods, Mark Zuckerberg, Bill Gates, or Elon Musk, average people will not talk about their failures and why they are stuck in life where they are.
In trading: The Self-enhancing transmission bias can be found especially where traders offer and sell trading strategies, systems or private trading rooms. A 2012 study by Heimer and Simon proved that individual traders are more likely to buy and follow a system if the vendor talks positively and frequently about his superior performance, even without verifying his performance. Traders who act as vendors can therefore increase their sales by purely sharing lies about their trading performance.
Conclusion: Humans Are Not Made To Be Profitable Traders
As you can see, psychology and research show that humans are not made for trading and second, that our belief system can be used against us by smart trading marketers. The takeaway message of this article is that being aware of how your brain works when trading is a key element on the way to becoming a profitable trader and it helps you avoid some of the most common trading traps.