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Trading psychology feature
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Herald the dawn of the computer age, and the time in which information doubled was cut to five years. Today it’s estimated that the amount of information we are exposed to doubles every eighteen months, a daunting task for our minds to manage.
Investors are increasingly flooded with information. But the problem with being at the mercy of too much information is that - due to limited time and energy - we increasingly rely on our instincts, assumptions and beliefs. And as noted previously, there are grave dangers in doing this.
According to psychologists, when surrounded by a confusing array of signals and information, investors often fall victim to biases, labelled “cognitive biases” that impede their ability to make sensible and successful decisions. While it isn’t possible to outline every bias, it’s worth mentioning a couple of the important ones. Investors looking to improve their results should be familiar with as many typical cognitive biases as possible.
Anchoring
People often “anchor” to a particular number, or to specific information and then adjust according to this specific value. For example: I tell you the number 50, and then ask you to pick a random number. I then tell your friend the number 4007 and ask them to choose a random number. It’s likely that you will choose a number in the vicinity of 50, such as 30 or 47, whereas your friend will probably choose 3006, or somewhere thereabouts, since they anchored to the number 4007.
Likewise, investors and traders often anchor to particular numbers, which influences their choices.
For instance, investors will often hang onto a losing share, arguing: “I will sell out once it hits $5 a share,” which is the price at which it was purchased. However, once purchased, the original price of $5 is irrelevant. Instead a share should be valued independently, and if it is losing money and there are good reasons to sell out, then the investor is probably better off cutting their losses and investing the funds elsewhere.
Confirmation Bias
Confirmation bias is probably one of the most common biases that investors stumble upon. Basically, it’s the tendency to look for information that confirms our original beliefs and opinions and avoid information that belies it.
For example, you buy shares in Telstra and then spend the rest of the week hunting through the newspaper searching for good news stories. Investors have a tendency to accord too much weight to information that concurs with our beliefs and too little weight to conflicting opinions and ideas. Instead, we’d be better placed to seek all information, not just information that confirms our original belief.
Self-serving bias
A similar tendency, but in retrospect, self-serving bias is the practice of claiming more responsibility for your successes than failures. Traders often remember the good trades that they’ve done and forget the bad trades. A series of good days on the market are easily remembered, whereas repeated small losses are not. The problem with this bias is that, if you can’t easily recall when you lost money, then you can’t learn from past mistakes.
Herding
Most investors should be familiar with the mentality of herding; that of copying the actions of others around you due to the, often incorrect assumption, that other people know what they’re doing. Investors often make investing decisions based on the collective actions of the market; for instance, everyone is buying BHP Billiton, so I should buy BHP as well. Or, everyone is racing into buying property during the boom, so I better buy before it’s too late. It’s often the case that the fear of missing out on a gain is stronger than the fear of loss.
So rather than individually assessing the merits of an investment, many investors simply run with the herd. Trend traders being the exception (these traders make money from spotting a share price trend and riding it), investors may be better off making independent investment decisions rather than running with the herd.
According to economist, Karl Popper, arguably one of the last century’s greatest thinkers, if we are to progress as a society and as individuals, rather than trying to prove that our theories and beliefs are correct and valid all of the time - we should be making an effort to falsify them. For instance, I believe that futures trading is risky and that losses once started, will flow like a tap, as my mother once told me. How could this assumption be incorrect? Well, for starters, many traders use protective tools such as guaranteed stop losses to control losses, which automatically trigger a sell order at a pre-determined price. When using guaranteed stop losses, futures traders can control risk, or the losses that they may incur. So Mum was wrong – Mum being always right is another assumption I’ll have to grapple with...
Popper’s motto is: “I may be wrong and you may be right, and by an effort, we may get nearer to the truth.” Indeed, if we consistently try to find fault with our beliefs – “is property really safe?” “do all internet stocks perform like Google?” then we will come closer to making sensible investing decisions, and therefore to becoming successful traders and investors.
More articles from the latest edition of CompareShares
Economics: Wolf, wolf!
Economics: RBA to raise rates to 7.0% at one of the next two meetings
Rates: RBA ups interest rates to 11-year high
Rates: Households 'should rethink budgets'
Trading: Buy the rumour, sell the fact
Investing: Why investors shouldn't trust their own judgement
Forex: Hitchhiking on the carry trade
Commodities: Global commodities bull flexes its muscles
Toni Case is Australia’s first journalist to specialise on contracts for difference (CFDs). She was a staff writer for Shares, Personal Investor and Asset Magazines, and today is a regular columnist with the Australian Financial Review. She is a qualified financial adviser.
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