Trading psychology – The 3 biases that could be your ‘undoing’

The Undoing Project is a novel by bestselling author Michael Lewis, perhaps better known for the books that lead to critically acclaimed box office hits such as The Big Short and Moneyball.

The book is about two psychologists, Danny Kahneman and Amos Tversky, who went on to challenge common thinking in the field of behavioural psychology. The pair highlighted the common behavioural pitfalls we are all susceptible to when making decisions.

A number of these concepts translate to trading and investing really well, and perhaps by understanding them and acknowledging them, you can stop them from derailing your trading.

1. Recency Bias

This is a simple one, it occurs when people put more weight on events that are more recent than those in the past.

Consider the effect on your mentality when one of your stocks has gone in the wrong direction for a day. Even though the trend was in your favour when you entered the trade and this particular day may only be a minor blip, some part of you still feel like it’s never going to turn back in your favour.

Recency bias can really override a traders sensibility, and often causes them to exit a trade too early rather than follow their pre-set rules.

2. The Endowment Effect

This bias occurs when you overvalue something that you already own – regardless of its true worth.

This is the thought that creeps in when you have reached the point when it is time to take profit, or cut your losses. You may have reached the exact target that you set out to achieve, yet you are still reluctant to pull the trigger.

When taking a loss, maybe this bias happens because it realizes the loss and we just don’t want to accept that fact. When taking a profit, it might just be a case of over-attachment to that winning trade currently in your portfolio – or perhaps it’s simply just a bit of greed…

3. Confirmation Bias

Confirmation bias occurs when people believe only what they want to believe. I’m sure we can all relate to this on some level and some particularly stubborn people in your life spring to mind.

But when it comes to trading, a good example of this in practice is when you overemphasize news you hear that works in your favour, and disregard what doesn’t.

Most won’t admit that they are susceptible to this type of bias, but in reality it’s always there subconsciously. That little news article talking up one of your stocks is genius, but the big one slamming the same stock is rubbish…