What makes a good trader? This question is essential to ask for any new trader who enters the field of trading or investing. The important traits of a trader or investor is discipline, continuous learning, practice and perseverance, and more importantly, self-awareness. Self-awareness refers to being aware of the possible behavioral biases that hinder the decisions of a trader.

Before, during, or after taking a trade, there are various thoughts, decisions, and feelings going on subconsciously and consciously that can affect the results of a particular trade. Today, we are going to learn about, and address, some of the biases a trader or an investor face.

What are biases?

The definition of Bias is to feel or show inclination or prejudice for or against someone or something. In finance, bias refers to showing inclination or prejudice towards a set of information than the other set of information. These biases often stem from human psychology, ego, and loss aversion instincts of humans. This is why biases are also known as behavioral biases. These biases are a natural response of a human being when there is monetary or any kind of loss at stake.

Behavioral biases are relatively new concept in the field of finance. Because the decisions are taken by the humans, it is important to understand how these decisions are made and the biases that affect these important decisions. Some of the important biases uncovered are:

1. Loss-aversion bias

2. Confirmation bias

3. Ownership bias

4. Herd mentality

5. Anchoring

6. Overconfidence bias

Let us understand these biases and see how to deal with them

Loss-aversion bias: Loss aversion bias refers to the tendency to strongly avoid any kind of loss. The fear of loss is more than the pleasure of gains. This bias can often lead to procrastination, or decision paralysis; where, the trader cannot take any decision about the trade. They just stay in the sidewalk and do nothing with the information that may favor a particular action. Even if the trade is taken, the trader displaying this bias often exit even at small, short-term correction in price.

Confirmation bias: Confirmation bias refers to the tendency to search, interpret, and focus only on the set of information that confirms an already held hypotheses. For example, if a trader has taken a trade in a bullish direction and the price enters a bearish trend, then the trader with this bias will try to justify the action taken and focus on the set of information that confirms his action.

Ownership bias: This bias is also known as Endowment bias. This refers to placing more value to an asset when it is owned by an investor or trader than when it is not owned. This bias can result in the person not selling an asset even if it is a loss making one, and denial.

Herd mentality: This bias is an outcome of wanting the social validation of the community members. Human beings are social animals and seeking validation from the tribe members is an innate emotion. This bias refers to following what the majority of the members are doing. This can mean buying into stocks that everyone is buying into. This can often lead to bubbles and crashes like the GFC of 2008 in America.

Anchoring: This bias refers to prioritizing the first set of information analyzed or received and taking newer information lightly. This can often result in the trader taking decisions based on information no longer relevant. This can be seen in participants who hold on to stocks which have taken a massive dive, with an expectation that the price will revive in the future. Person with this bias dismisses the new piece of information as incorrect or irrelevant.

Overconfidence: Overconfidence refers to showing unwarranted faith in one’s abilities. Overconfidence can lead to justifying any kind of loss and self-appreciation when lucky. Overconfidence results in lack of feedback and leaves no room for improvement. This can lead to complacency and lack of adaptation. Market participants with overconfidence can overly rely on their “gut feeling” rather than the objective study of the data. This bias makes the trader underestimate the risk and sometimes overestimate the expected returns.

Dealing with biases

Emotions are essential for any human being. But when they take the form of biases, they hinder the trading and investing activities. The first step to dealing with these biases is to become consciously aware of them when they are taking place. The second step is to instill a discipline in trading. This means to create a trade setup and follow the rules religiously.

Biases like ownership bias, anchoring, and confirmation bias can be avoided by being objective about analysing the data. It means looking at the data for what they are and what they mean and not wishing or hoping for what they would be. For example, if the data is showing bearish signs and the current positions are bullish, the objective thing to do would be reduce the position size, be selective of the stocks to trade, or trade with the trend. This is far better than labeling the data as incorrect or irrelevant.

To avoid loss-aversion and herd mentality, we must be comfortable with taking losses and being wrong. They are part of the process. Not everything can be controlled, and uncertainty exists where there is reward. What can be done is effective risk management.

I have faced these biases in the initial part of my trading journey. I have not gotten rid of them, rather, I have learned to control them and deal with them. It was only through trial and error and losses that I have been able to control them. Any new trader will face these biases until they learn to deal with it. But the time to do this can be reduced with discipline, objectivity, and risk management. These are some of the things I teach in all my courses. The right way to manage the risk, to build trade strategies, and to analyse the price with objectivity. If you are new to the markets and want to learn more about these, do check out TNT One membership. 👇🏻👇🏻👇🏻