There are enemies we know about in trading, such as bogus information, outlandish promises of wealth, and financial risk. Once aware of these threats, we can take steps to monitor outside information and protect ourselves. Yet some of the greatest risks we face as traders are from within. The market may be blamed, but it is how we react in response to the market that caused the huge trading loss or missed opportunity. Here are seven psychological traps that are prevalent in trading; becoming aware of them is the first step toward improving, and the next step involves creating a plan to overcome these traps in real-time.
Exposure bias is when we form an opinion based on the most readily available information, without checking to see if the information is correct. A news anchor may make a witty financial comment that goes viral, and in turn becomes “common knowledge.” Traders then act on this information believing they are doing a good thing, yet the original source of the information may have been inaccurate. Just because you hear something often, doesn’t mean it is true.
Because so much news is available—we are overexposed to it—a trader may believe they need more and more information to be an effective trader. This is an exposure bias. Nothing dictates that more information will make you a better trader. In fact, protecting yourself from the many biases inherent in the comments of others may actually makes you a better trader, because your trades will only be based on your own convictions, strategy and research.
Confirmation bias is the tendency to draw a conclusion first, and then rationalize the decision after. Humans have a natural tendency to do this. Instead of testing out a market strategy and spending several months in a demo account to make sure it is profitable, most traders jump right in, assuming the strategy works, betting real money on it. They made the conclusion before getting the facts. No matter what happens, the trader can rationalize the choice; the strategy works and they are genius, or the strategy fails and they have the excuse that the strategy wasn’t tested.
The only way out of this trap is to keep an open mind when first exposed to something new. Attempt to verify the information before acting on it. Seek evidence that confirms and denies your suspicions, and then draw a conclusion based on all the evidence.