Cognitive Errors - Trading Biases - Quantified Trading Strategies

Trading Course (Get Started In Trading) Cognitive Errors – Trading Biases

In this lesson, we take a deeper look at the psychological aspects of trading. From the last lesson, you learned that trading psychology is just as important as the strategies. After all, what is the point in a quantified strategy if you don’t follow the rules?

“Investing is not the study of finance. It’s the study of how people behave with money.”

Morgan Housel

What is a cognitive error?

A cognitive error is a failure to think clearly. We can argue it’s a systematic deviation from logic – what would be the optimal and rational thoughts or behavior. These errors are often called behavioral biases.

Why do we have biases? One explanation is that we are more used to make quick and hasty decisions to avoid dangers. On the savannah, when you see a lion, you don’t sit down and think – you look for cover as soon as possible. But this logic doesn’t work in trading.

One very typical bias is called overconfidence bias: we are more likely to overestimate our knowledge than we are to underestimate it.

Think about this example: If we ask someone if they understand how a zipper works, most people would nod and say yes. However, if we tell them to sit down and make a technical drawing with an explanation, hardly anyone is able to do it!

The most obvious cognitive errors:

All traders make mistakes (more or less all the time). These are the typical errors:

Overconfidence: we are more likely to overestimate our knowledge than we are to underestimate it.
Anchoring: we “anchor” our mindset to past prices. For example, you don’t want to buy stock ABC until it drops down to 50, the bottom three years ago.
Loss aversion: we react more negatively on losses than positively on gains.
Steady gains vs. lump-sum rewards: if you make 100 000 a year for five years in a row, you’ll have five years of joy. If you make 500 000 in year one and nothing in the last four years, you have one enjoyable year and four miserable ones.
Gambler’s fallacy: the erroneous belief that if a particular event occurs more frequently than normal during the past it is less likely to happen in the future.
All-or-nothing: if you fall short on your expectation, you see yourself as a failure.
Survivorship bias: we only see the winners, not the losers.
Confirmation bias: the tendency to search for, interpret, favor, and recall information in a way that confirms or supports one’s prior beliefs or values.
Herd mentality: to copy and follow others.
Self-serving bias: the propensity to attribute positive outcomes to skill and negative outcomes to luck. Also called “resulting”.
Framing bias: when someone makes a decision because of the way information is presented to them, rather than based just on the facts.
Hindsight bias: the theory that when people predict a correct outcome, they wrongly believe that they “knew it all along”.
Anecdotal bias: when given a “case-study” we erroneously form decisions without studying the whole population.
The endowment effect: is the finding that people are more likely to retain an object they own than acquire that same object when they do not own it (hang on to losing positions).

The list is long, this is just a small fraction of it.

Why you need to understand cognitive errors:

Trading is all about decision-making. But we tend to think in black and white, or all or nothing, and this leads to polarized thinking. We take mental shortcuts all the time! In trading you need to be aware of your mental shortcuts, for example the ones mentioned above. The more you are aware of your biases, the better you can implement your trading. We would say this is more important than your trading.

The investor Charlie Munger is famous for his inverse thinking: focus on error removal and success will take care of itself.