e-Book: Trading Psychology – Part 3 – Confirmation Bias

Confirmation bias is the habit of only looking for information that supports your beliefs. If you anticipate the price of BHP Billiton (BHP) is going to rise, for example, you will only really take in news and data that reinforce your belief.

Traders who pursue confirmation of their beliefs tend to miss warning signs that would otherwise protect them from unnecessary losses. Ultimately, this can only lead to losing money because decisions to buy or sell, or even to do nothing, are being made on false premises.

To know if you have any confirmation bias tendencies, ask yourself, “How often do I look for signs that I may be wrong in my analysis?” If your answer is rarely or never, you may be a confirmation seeker and you need to actively work to ensure that such a bias never interferes with your better judgment.

One way to overcome confirmation bias is to find an individual or group with whom you can discuss your trading. You don’t need somebody who will perpetually agree with you. Traders with different perspectives and ideas will help you to be more circumspect. Sometimes your convictions will only be reinforced by talking with other traders, but at other times, they may force a total and timely rethink.

Loss aversion bias is based on the theory that losing $1,000 will have a bigger impact on you emotionally than gaining $1,000 will. In other words, fear is a more powerful motivator than greed.

Ironically traders who fear losses are much more likely to hold onto losing positions than traders who are able to accept short-term losses and exit their trades. A reluctance to give up a losing position will not only cause you to incur bigger losses but also preclude you from finding better alternative positions.

If you want to know if you have any loss aversion tendencies, ask yourself, “Have I ever held onto a losing position, beyond the point where I knew I should have quit, because I hoped the trend would reverse and wipe out my losses?” If you have, then you need to be aware of that tendency.

One way to overcome a loss aversion bias is to trade with physically-set (i.e. automatic) stop-loss orders. Many traders trade with just a mental stop-loss that, when it comes to the crunch, they fail to honour. They let their emotions interfere with their better judgment as they try to justify irrational decisions that prevent them from quitting and cutting their losses.

In conclusion, as soon as you invest in anything you should set your stop-loss order. It should be physically set, operate automatically, and you should respect it.

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