Thursday, March 18, 2010

Overcoming Cognitive Biases in Trading: The Value of Behavioral Finance

A recent article on the Minyanville site does a nice job of describing some of the cognitive biases that traders experience and what they can do about those biases.

A cardinal concept from behavioral finance is that we do not process information about risk, reward, and uncertainty in a purely objective manner.

A key idea in psychology is that you are less likely to fall prey to information-processing biases if you are fully aware of those biases.

Take recency bias for example. When I was in school, I created a simple experiment: I asked people to look at the charts of stocks and predict whether the next move was going to be up or down. The charts were identical, except for the last bars. In half the cases, the last bar was up (green color); in the other half, the last bar was down (red color).

Sure enough, significantly more people thought the market was going to go down if the last bar was red than if it was green. They overweighted the last piece of data in coming to their conclusions.

This happens to traders all the time. They see the market rise, become convinced that a trend is under way, don't want to miss the move, and they jump aboard the rising market. Sure enough, that's right about the time the market is ready to reverse.

If traders are cognizant of recency bias, however, they can make a conscious effort to look beyond the last bar and fully assess buying and selling pressure, longer-term trends and patterns, etc.

Understanding the behavioral finance literature may not make you a good trader, but it can be very helpful in preventing you from becoming a bad one.

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3 comments:

Flowtastical said...

Doc,

With the volatility created by black box programs intra day traders are often the casualty of a algorithm that swipes up or down 20 cents(last available information).

If at that time you are out of the money 20 cents with an stop loss of 10 cents, what advice can you give us to make a logical decision rather than eliminate our position?

bustem said...

Yeah, this is good stuff. There are a ton of these cognitive biases that we humans exhibit time and time again. Some of the studies that have been done are really interesting stuff. And the biases explain so much, especially in the market and with bubbles.

I've always had trouble understanding why we do these things. It's evolution stuff--survival of the fittest--turns our brain will think how we want it to think in order to produce the behavior we want. However, most times this results in failure, like the recent financial crisis, and not survival. I did read a different explanation once, something a little different that said human evolution requires some major risks, even ones that are irrational.

bustem said...

Those recommendations to overcome cognitive biases are really good. Surprisingly, it's actually quite difficult to overcome these biases, even if you know about them. What works best though are methods like the other discusses--you almost have to trick your mind again, or at least force it to think about things in a certain way to overcome these biases. What does not work is merely telling yourself you are no longer going to do them.

Even then it is still hard to do. I find that there are few people that can truly do it. Warren Buffet may be the best in the world at it I think. His investing philosophy sounds so simple, and whenever I hear him talk, I get all excited every time and tell myself I'm going to go follow it. But each time I never get past Buffet's rule #1: never buy a stock unless you plan to own it for at least ten years.