CAPICHE • SEASONED
Don’t Get Suckered Again
BIG IDEA: TO ERR IS HUMAN. YOUR BUILT-IN COGNITIVE
BIASES CAN TRICK YOU INTO MAKING POOR TRADING
DECISIONS. HERE'S HOW TO DAMPEN THEIR IMPACT.
• WE LOVE MIRRORS: They help us brush
our teeth, perfect our dance moves, or remind us that our clothing choices are fantastic. But cognitive mirrors can go further. As
reflections of past behavior and experience,
they can help our brain decipher reality.
How often have you made what turned
out to be a poor trading decision? Looking
back, perhaps you can see that your actions
were based on faulty or insufficient information, possibly previously held beliefs that
led you astray. This phenomenon is called
cognitive bias, and we’re often unaware of its
potential to impact our trading decisions. So
how can we mitigate negative influences?
FAST VERSUS SLOW
Behavioral economist Daniel Kahneman
detailed two systems of thought that shape
general brain function. System 1 is fast, auto-
matic, intuitive, and largely unconscious—it
oversees things like pulling your hand out of
a flame. System 2 is deliberate and analytic.
Think balancing your checkbook or doing
Both mental systems come into play when
you trade. For example, if a trader sees a price
anomaly like a flash crash, she may act on it
because she sees an opportunity—or a signif-
icant risk. This is System 1. System 2 comes
into play if the trader evaluates a complex
option strategy with multiple legs, or takes a
concentrated position with significant capital.
Hundreds of cognitive biases exist in both
systems and can cause humans to act irra-
tionally. They’re neither good nor bad. They
BE HERE NOW
Numbers can’t begin to capture the range
of behaviors, emotions, and life experiences
that drive human decisions. Although many
traders rely on quantitative and qualitative
analyses to help make trading decisions,
• Confirmation bias: Traders may focus
on information that confirms a preexisting
belief even as they ignore objective data.
• Anchoring: Traders might jump to a conclusion based on the first piece of information received or their previously held beliefs.
• Overconfidence: Traders may have too
much faith in their own analysis or ability,
leading to higher-risk asset purchases or
risky concentrated positions.
• Loss aversion: Traders may sell assets
that have a gain, and retain assets with a loss
(hoping the loss will reverse).
• Representativeness: Traders may assume
that recent performance is an accurate indicator of future performance.
• Herding: Traders may follow the crowd.
• Emotional attachment: Traders may get
emotionally tied to an investment.
FEAR NOT THE BRAIN
To mitigate negative cognitive bias influences when you trade, study how they function.
Try looking at your data differently. Here are
a few steps you can take to help dilute those
• Be aware. Biases exist. Identify and understand them. Analyze carefully.
• Be objective. Every trader needs to establish investment goals. What instruments
should you buy or sell, and why? What’s your
time horizon? Do you have the same or different goals for all security types or sectors?
• Be fluid. Research information from many
sources and consider multiple perspectives.
• Be open. Talk to others with different
opinions to help you challenge your own
perceptions and conclusions. Engage in freewheeling discussions to generate new ideas.
MIRRORS AND MORE
Reflecting on your past trades and identifying what went wrong can be a powerful
analytic tool for correcting future decisions.
Yet being aware of cognitive biases can also
help you stay in the present, keeping an eye
on those subtle mental functions that could
make or break your trades.
Ho w are the
two linked? Read
“Three Steps for
Saving & Investing