Common Psychological Biases in Trading

Common psychological biases in trading are like optical illusions. The market is the image, and your mind sometimes sees patterns or trends that aren't really there. Recognising these mental pitfalls, like seeing movement in a static picture (confirmation bias) or thinking the image changes after staring at it too long (overconfidence bias), helps you avoid making hasty or irrational decisions. By training yourself to see the market clearly, you can overcome these biases and make more rational trading choices.

In the world of trading, making rational and well-informed decisions is crucial for long-term success. However, even the most seasoned traders are vulnerable to psychological biases that can cloud judgment and lead to costly mistakes. These biases arise from cognitive shortcuts and emotional responses, often influencing traders to act irrationally or impulsively.

In this article, we’ll explore some of the most common psychological biases in trading, how they affect decision-making and strategies to overcome them for more disciplined trading.

What Are Psychological Biases?

Psychological biases are cognitive distortions or errors in thinking that lead to irrational decisions or judgments. These biases are often subconscious and are influenced by emotions, past experiences, or preconceived notions. In the context of trading, biases can cause traders to deviate from their strategies, take on excessive risk, or misinterpret market data.

Common Psychological Biases in Trading

Let’s take a closer look at some of the most prevalent biases that traders experience and how they manifest in trading decisions:

1. Confirmation Bias

Confirmation bias occurs when traders seek out information that supports their pre-existing beliefs or opinions while ignoring evidence that contradicts them. This bias can cause traders to hold onto losing positions or ignore signs of a market reversal because they only focus on data that confirms their initial analysis.

Example: A trader believes that a stock is going to rise and only pays attention to positive news and upward price movements, ignoring any signs of weakness or negative news that suggest a potential decline.

How to Overcome It: Traders should make a conscious effort to consider opposing viewpoints and analyse data objectively. Keeping a trading journal and reviewing both successful and unsuccessful trades can help develop a more balanced perspective.

2. Loss Aversion

Loss aversion is the tendency for traders to prefer avoiding losses rather than acquiring equivalent gains. This bias can cause traders to hold onto losing trades for too long, hoping that the market will turn in their favour, which often leads to larger losses.

Example: A trader buys a stock at ₹1,000, and the price drops to ₹900. Instead of cutting their losses and exiting the trade, the trader holds on, hoping the price will rebound, only to see the stock fall further to ₹850.

How to Overcome It: Implementing strict stop-loss orders and sticking to them can help traders manage losses without letting emotions take over. Understanding that small, controlled losses are part of the trading process is key to minimising the impact of loss aversion.

3. Overconfidence Bias

Overconfidence bias occurs when traders overestimate their ability to predict market movements or the accuracy of their analysis. This often leads to taking excessive risks, such as over-leveraging or making large trades without adequate research, believing that success is guaranteed.

Example: After a few successful trades, a trader becomes overly confident and increases their position size on the next trade, assuming it will also be profitable. The trade goes against them, resulting in a larger-than-expected loss.

How to Overcome It: Traders should maintain a consistent risk management strategy, regardless of past successes. Avoid increasing position sizes impulsively, and always conduct thorough analysis before entering a trade.

4. Anchoring Bias

Anchoring bias occurs when traders fixate on a specific piece of information—such as the price at which they initially bought an asset—and use it as a reference point for all future decisions, even when the market conditions change.

Example: A trader buys a stock at ₹1,200, and the price falls to ₹1,000. The trader continues to anchor to the original ₹1,200 purchase price and refuses to sell, even though the stock shows signs of further decline.

How to Overcome It: Traders should focus on current market conditions rather than fixating on past prices or data. Setting predefined exit points based on technical analysis rather than emotional attachment to specific prices can help combat anchoring bias.

5. Herding Bias

Herding bias occurs when traders follow the actions of the majority, assuming that if everyone else is buying or selling, they should do the same. This often leads to impulsive decisions without proper analysis, resulting in buying at the top of a rally or selling at the bottom of a dip.

Example: A trader sees that a stock is gaining rapid popularity and jumps in, buying at a high price without conducting their own research. Soon after, the stock price falls, and the trader suffers a loss.

How to Overcome It: Traders should avoid making decisions based solely on market sentiment or the actions of others. Conduct independent research and ensure that trades align with your strategy and risk tolerance.

6. Recency Bias

Recency bias is the tendency to give more weight to recent events or data while overlooking historical trends or long-term patterns. Traders affected by recency bias may overreact to short-term price movements or news, making rash decisions based on the latest information.

Example: A trader sees that a stock has risen sharply over the last few days and decides to buy, ignoring the fact that the stock is overbought and may be due for a correction.

How to Overcome It: Traders should review longer-term trends and use technical analysis tools, such as moving averages, to get a broader view of the market. Avoid making decisions based solely on short-term price action.

7. The Disposition Effect

The disposition effect refers to the tendency for traders to sell winning trades too early while holding onto losing trades for too long. This happens because traders want to lock in profits quickly to avoid the risk of losing them, but they are reluctant to accept losses.

Example: A trader sells a stock after it gains 5%, even though the market conditions suggest that the stock could continue to rise. Meanwhile, the trader holds onto a losing trade, hoping it will eventually recover.

How to Overcome It: Traders should set profit targets and use trailing stops to let winning trades run while capping losses on losing trades. Developing a disciplined approach to both exits and entries can prevent the emotional urge to act prematurely.

How to Overcome Psychological Biases in Trading

While psychological biases can’t be completely eliminated, they can be managed by adopting certain practices and mindsets:

1. Develop Self-Awareness

The first step in overcoming biases is recognising them. By regularly reflecting on past trades and identifying patterns of behaviour, traders can become more aware of their biases and take steps to correct them.

2. Create and Follow a Trading Plan

A well-defined trading plan reduces the influence of emotions and cognitive biases. Having clear rules for entries, exits, position sizes, and risk management ensures that decisions are made based on logic and strategy, not emotional impulses.

3. Keep a Trading Journal

Maintaining a trading journal allows traders to track their decisions, emotions, and outcomes. By reviewing trades, traders can identify recurring biases and develop strategies to mitigate them. Journals provide valuable insights into the thought processes that lead to both profitable and losing trades.

4. Focus on Risk Management

Risk management tools, such as stop-losses, position sizing, and risk-reward ratios, help traders limit the impact of psychological biases. By capping potential losses and planning for different scenarios, traders are less likely to make impulsive decisions.

Example: Recognising and Overcoming Biases in Infosys

Let’s say a trader buys Infosys at ₹1,500, anticipating a rise based on positive earnings reports. The stock rises to ₹1,600, but the trader sells too early due to the disposition effect, fearing that the gains could be lost. Meanwhile, the trader holds onto another stock that has fallen 10%, influenced by loss aversion, and refuses to cut the loss.

By recognising these biases, the trader could adjust their strategy by setting clear profit targets and using stop-losses to cap losses. This would prevent emotions from overriding logic and lead to more consistent trading outcomes.

Common Mistakes in Trading Psychology

Here are some common mistakes related to psychological biases that traders should avoid:

1. Ignoring Data that Contradicts Your View

Letting confirmation bias drive your trading decisions can result in ignoring valuable data that suggests your trade is moving in the wrong direction.

2. Overconfidence After a Winning Streak

Overconfidence can lead traders to take excessive risks or abandon their trading plan, believing that they are immune to losses.

3. Failing to Cut Losses Early

Due to loss aversion, traders often hold onto losing trades longer than necessary, hoping the market will turn around, which can result in even larger losses.

Conclusion

Psychological biases are an unavoidable part of trading, but recognising and managing them is essential for long-term success. Biases such as confirmation bias, loss aversion, overconfidence, and herding can cloud judgement and lead to irrational decisions. By developing self-awareness, sticking to a solid trading plan, and focusing on risk management, traders can reduce the impact of these biases and make more rational, disciplined decisions.

In the next chapter, we will explore Building a Trading Plan, a structured approach that helps traders set clear goals, define strategies, and establish rules for managing risk and executing trades effectively.