Biased Mind: Enemy of Trader

Trading with a biased mind?

Make sure you're not making these mistakes
Over the weekend I am re-reading a book by Dr. Van Tharp called 'Trade your way to financial freedom'. Below I am typing out some insights gleaned from the book. Some of it is reproduced verbatim and the rest has been summarized by me. The text in brackets is my own comments.

''We typically trade our beliefs about the market and once we have made up our minds, we're not likely to change them. And when we play the markets (based on those beliefs) we assume that we are considering all the available information. Instead, our beliefs, through selective perception, may have eliminated the most useful information.

Overall, a basic source of problems for all of us is coping with the vast amount of information available. Since the human brain can only cope with limited information, we tend to ''generalize, distort and delete'' the info that we cannot cope with. This distorted view then becomes a bias and affects the way we trade.

Very often these biases (or distorted signals) lead to bad trading decisions.Van Tharp has categorized these biases as follows:

1.Representation Bias

''People assume that when something is supposed to represent something, then it really is what it is supposed to represent'' Basically that means we try to make sense of nonsense, or data that's not supposed to make sense.
For example, daily bar charts. A chart is by itself a generalization, as it doesn't show you how much activity happened at what price. Yet many people tend to use it to predict statistical probabilities ''given that X happened, what is the likelihood of Y?'' People 'assume that market indicators are a reality, rather than attempts to represent something that might occur'.

The representation bias can be described by our bias to ''judge something by what it looks like as opposed to what its probability rate is''. (One can know their probability rate by testing how many times the market actually behaves in the projected manner vs how many times it doesn't)

2. Lotto Bias

(This one derives its name from the American state run lottery, which allows you to choose some numbers on your lottery ticket. You chances of winning with any given number are about 1 in 13 million. Still, just because you get to choose some numbers on your ticket it gives you a false sense of control.) ''This is exactly what occurs in the speculative markets. People believe they can make a quick dollar by picking the right numbers. ''You get a sense of control with entry signals because the point at which you choose to enter the market is the point at which the market is doing exactly what you want it to do. As a result, you feel like you have some control, not only over your entry but over the market. Unfortunately, once you are in a position, the market is going to do whatever it wants to do - you no longer have any control over anything EXCEPT YOUR EXITS''

3. Conservatism Bias

''The implication of this bias is that most people search out what they want, or expect, to see in the market. Most people, as a result, are not neutral with respect to the market, and they cannot go with the flow. Instead, they are constantly searching for what they EXPECT to see''

4. Randomness bias

'People tend to assume that the market is random - that prices tend to move according to random chance. Second, people make erroneous assumptions about what such randomness...might mean'

'One reason people like to pick tops and bottoms is that they assume that the market can, and will, turn around at any time. Basically, they assume that the market is random.'

'Even if the markets were random, people fail to understand randomness....When a long trend does occur in a random sequence, people assume that it is not random.....People seek patterns where none exist'...(and blow up the importance of insignificant data)

5. Need-to-understand bias

(People feel the need to have a reason for whatever the market is doing.The media feeds our need to understand the markets with their own stories and opinions. If the market opens up the media will instantly come up with a reason (story) about it. If it starts to trend down, the media again has a reason. If it finally closes up, the media has a reason for that too. It's hard to understand the market, and even harder to accept that we don't understand the market. But for our sake they try lol.)

6. The 'I'm Right ' Bias

''People have an overwhelming desire to be right.'' This makes it harder to get out of a losing position, leading to even bigger losses.Ónce a person makes a prediction, their ego becomes involved in it, making it difficult to accept (any market occurrence) that seems to differ from your prediction. Thus, it becomes very difficult to trade anything that you publicly predict in any way'.

7. Gambler's bias

People assume that just because they've bad a bad losing streak, their probability of winning is much higher. (Heck, I have that bias LOL. In fact, if I have a winning streak then too I become nervous that my next trade would be a big loser.)

Win / Loss is directly proportional to Self understanding.