Understanding Emotional Biases In Trading

We all have blind spots in our trading psychology, and emotions that can either get the better out of us or can make us take suboptimal decisions. These cost you time, money and mental health. Investing biases fall into two main categories: Cognitive and Emotional

Cognitive biases generally involve decision-making based on faulty reasoning, therefore better information, education and advice can often correct for them. Cognitive bias involves using mental shortcuts or "rules of thumb" to make decisions.

Let’s find out more on emotional bias below.

A definition of emotional bias

A bias is a skewed perception of reality, a spot where an individual can’t see things clearly due to preconceived, incorrect notions. Emotional biases are some of the most complex, as they involve our feelings, headspace and mental wellbeing. The study of these behavioural biases, relating to money, is called Behavioural Finance, or Behavioural Studies.

In other words, emotional bias is what happens when your perception of a situation, or the conclusions you draw from it and the financial decisions you take, are clouded by emotional impulses that you don’t realise are incorrect, illogical or detrimental to you. It’s a so-called ‘blind spot’ in our logic, which is overruled by strong and irrational feelings.

The benefit of understanding emotional biases in trading

“Economic cycles are almost entirely driven by emotion,” says Pepperstone analyst Michael Brown. And indeed, many experts believe that most traders’ and investors’ responses to the market’s movements are primarily reactions to their perceptions of what’s happening, rather than rational decisions taken based purely on facts.

This is one very good reason to understand emotional biases - because they might not only be ruling you, they’re almost definitely ruling other market players as well. This can be used to your advantage in a very active and/or volatile market, to overcome the ‘noise’ and emotions others are falling prey to.

Common emotional & cognitive biases to watch out for

So how does one exercise emotional biases? Knowing what they are is the first step to awareness of them in yourself. So, let’s look at common emotional & cognitive biases you might be suffering from:

1. Overconfidence bias (emotional bias)
2. Loss aversion (emotional bias)
3. Sunk-cost fallacy (cognitive bias)
4. Confirmation bias (cognitive bias)

Overconfidence bias

Overconfidence bias in trading is an incorrect assumption that you are more successful, or knowledgeable or ‘lucky’, than you really are. This trading psychology bias trips up many traders, for the simple reason that it’s very difficult to objectively judge one’s skill and level of expertise. It also directly affects how receptive you are to admitting your own mistakes and learning from others - two significant stumbling blocks that will get in the way of any trader improving their craft.

Loss aversion

The mental bias of loss aversion places more emphasis on the fear of making a loss, than on the possibility of making a profit. This can be detrimental as it can cause you to trade ‘defensively’, with an incorrect view of the markets as a series of potential losses, preventing a clear-eyed view of what’s actually happening on charts.

The irony of loss aversion is that it often does result in either financial losses, or far less gains than would have been possible. There is no reward without risk, as they say, and those with an aversion to all forms of risk (even moderate and carefully calculated ones) can be their own worst enemies in trading.

Sunk-cost fallacy

The sunk-cost fallacy is the unwillingness to close an unsuccessful position, and by doing so prevent further losses, simply because so much has been invested in the trade already. In this trader’s mind, the pain of admitting defeat and the size of the loss prevents them from cutting their losses, holding onto a bad trade even as the losses pile up higher.

This bias can result in the trader failing to see bad outcomes or their bad decisions accurately, downplaying them in their minds. That, or a ‘too late to turn back now’ perception of the situation. Both are especially common in financial decisions because the pain of the thought of losing potential profits can outweigh the rational observation that staying in such a position only puts more of your capital at risk.

Confirmation bias

The human brain tries to make meaning and patterns out of everything it sees - including the financial markets - sometimes correctly and sometimes incorrectly. A confirmation bias is a trick of the brain where you’ll see facts, figures and other data through a skewed lens in order to subconsciously fit your assumptions and theories.

In trading, this looks like interpreting the market movements in a way that fits with what you think will happen, then acting on those presumptions - rather than seeing them for what they really are and acting on the information accordingly. As such, it is when you tend to look for reasons to back up your investment opinion, as opposed to finding facts that might not support your decision. This might result in an investment decision looking better than it actually is.

Rational decision-making vs emotional biases in trading

Emotional bias can be difficult to spot - oftentimes, we believe we are being completely rational even while in the grips of biases. So, how can you tell emotional/cognitive biases and a rational decision-making process apart?

While it isn’t possible for anyone speculating on the markets to be either completely rational or completely irrational at all times, it’s important for traders to try for as much logical thinking in their trading psychology as possible, helped by an awareness of behavioural biases.

How to mitigate emotional bias in your trading strategy

Fortunately, there are several ways to overcome emotional biases, which have worked for many traders over the years.

• Get it in writing - take the time to thoroughly develop a specific trading plan, testing it for accuracy and efficiency. Write down the financial markets, position sizes and market conditions you want to trade and why. Then, keep this visible while you’re trading to remain focussed on your vision and not easily swayed by just anything occurring in the markets
• See your psychology in practice on a demo - create a demo account and practise risk-free on it. This can help you to see, in real time, what your strengths and weaknesses as a trader are, and to learn valuable lessons about emotional trading without having to forgo your capital to do so
• Calculate your level of risk versus reward - when emotions play havoc with the facts, sometimes a simple sum can help. Calculate the potential profit to be made from a position, then divide it by the potential loss that could also be made. This is your risk-reward ratio, and can help overcome cognitive errors like loss aversion or sunk-cost fallacy
• Reflect regularly - self-awareness is the key to overcoming emotional bias. Make use of a trading journal and frequently jot down your emotions, perceptions and habits during each trade
• Get a little help from your friends - it is difficult, sometimes impossible, to see out shortcomings or biases clearly. That’s why they’re called ‘blind spots’. Seek out a mentor or accountability partner who is experienced and trusted to will give you honest feedback on your positions and biases
• Don’t forget risk management - no amount of objectivity can prevent unexpected shocks or price swings and significant market fluctuations. So, always ensure that you consider setting stop loss orders and take profit orders to safeguard your capital if deemed necessary

FAQs

Do all traders have emotional biases? What if I’m one of the ones that just don’t?

Biases, assumptions and emotions are all part of human behaviour and our experience - they make us people. While some people are more intellectual/methodical, or more emotional/impulsive than others, everyone has some degree of all these things within them.

So, it’s safe to just assume that you have emotional biases. Then, go out and test this theory by taking an honest look at your trading psychology by studying your trades history, ideally asking experienced fellow traders you trust for their insights too.

Can you get rid of emotional bias?

Yes and no. Bias is one of the quirks of being human, but can be kept in check by being aware of it and constantly monitoring yourself for signs of it. Over time, this may become so automatic, with diligent practise, that your emotional biases have little to no power over you anymore.

How long does it take to get rid of emotional bias in trading when you’re a beginner trader?

It’s a lifelong journey, if you’re committed to not trading based on emotions or bias. Not only are emotions and cognitive biases complex, but new ones can crop up at any time. This one is definitely about the journey, not the destination.

Can emotional bias in trading ever be a good thing?

Emotional bias clouds our vision, and that can always be dangerous. Nevertheless, when you understand emotional bias, without letting it rule you, you can see where it impacts the average investor or trader in the market and can take advantage of that.

Picture it this way: driving a car blindfolded is a serious liability and likely to get you in danger. However, being aware that everyone else is driving around blindfolded, and knowing how the blindfold works so that you can avoid it, can be a real advantage and keep you away from danger.