The six biases that can influence traders

IG recently conducted comprehensive research to uncover valuable insights into how psychology impacts real world trading decisions. Throughout the project, our experts studied the results of over 30 million closed trades across 15 markets, examined third-party academic studies, analysed data from multiple surveys and consulted with several industry thought leaders. The following article has been developed using insights gained from this research.

Have you ever been faced with the pseudo-ethical dilemma of wondering whether you should tip against your own football team? If so, you’ll know that it can be quite an uncomfortable thing to do, because it just feels wrong -- even if the statistics strongly support the other team winning. This is an example of a bias getting in the way of your decision making, and it happens all the time in trading. But first, what exactly are biases?

Biases are subconscious but systematic ways of thinking that can occur when your brain takes a mental shortcut, and they can impact the way we make and implement decisions. In the investment world, there six well-defined biases that can influence trading decisions: availability bias, anchoring bias, hindsight bias, confirmation bias, loss aversion bias and gambler's fallacy. Read on to learn about them in more detail, and what you can do to help prevent them clouding your judgement.

Availability Bias

How does 'availability bias' affect traders?

Availability bias is the tendency to open or close positions based on information that is easily available, rather than sources that are more difficult to find. It can cause traders to act on false or unverified information, which can lead to higher levels of risk and loss.

Traders tend to lean towards what is personally most relevant, recent or emotional, even long after the event is over. The mind can take a shortcut based on examples that come to mind immediately, rather than on research and analysis. For example, if a person has a family member who recently lost money on a Bitcoin trade, they may be less inclined to speculate on the cryptocurrency.

In fact, a study by Moradia, Meshkib and Mostafaei found there’s a strong correlation between judgement and data availability. By surveying investors of stocks listed on the Tehran Stock Exchange, the researchers concluded that decision-making would likely improve as the amount of information released to the public increased.¹

How can traders prevent availability bias?

The most common way to prevent availability bias is to put in the time to conduct extensive research and analysis. Participants of IG's survey were comfortable using multiple sources to gather information on trading and investing. Although 56% used the internet, some also used newspapers, specialist publications, financial advisers, television and podcasts.

Fundamental analysis is used to examine internal and external factors such as learnings reports, how the sector is performing and the health of the economy, while technical analysis looks at historic price data and indicators to establish key entry and exit levels for each trade.

If you don't feel confident enough to trade on live markets, you could test your strategy on a demo account first. This enables you to practise trading and test your strategies in a risk-free environment using virtual funds.

Anchoring Bias

What is anchoring bias in trading?

Anchoring bias is the tendency for traders to allow an initial piece of information to have a disproportionate influence on future decisions, regardless of its relevance.²

For example, research by Kaustia, Alho and Puttonen showed that individuals’ estimates of stock returns were significantly influenced by the starting value they were given – the 'anchor'³. When participants were given a high historical stock return, they were more likely to estimate that the future return would also be high, while a group given a lower initial value had far lower estimates.

Anchoring bias can have dangerous consequences in trading, as it might mean that a trader holds onto an asset far longer than they should, or that they make an inaccurate assessment of an asset's worth based on the anchor value.

How can traders prevent anchoring bias?

The best way to prevent anchoring bias in trading is by performing comprehensive research and analysis of the market to identify your own anchor.

IG's study showed that only 28% of traders and investors used personal experience as a source of information. But by doing your own analysis of macroeconomic trends and historical data, you will be better placed to identify key support and resistance levels. It’s important to have confidence in your own plan before you look at someone else's estimates – whether this is an analyst or fellow trader.

Hindsight Bias

How does 'hindsight bias' affect traders?

Hindsight bias in trading is the tendency for individuals to express that they 'knew it all along', once they know the answer to a question or the outcome of an event that was previously uncertain.

The consequence of hindsight bias is that it often leads to a false sense of confidence. IG's survey found that up to 55% of traders believe that they are very disciplined when trading – however, this is a dangerous mindset because biases can creep in and lead to irrational trading decisions.

A study by Biais and Weber found that those who exhibited hindsight bias failed to remember how uncertain they had really been before they made their decisions. This means that they may have been inefficient in making choices regarding risk management. Of the 85 investment bankers surveyed, all were found to exhibit hindsight bias.⁴

How can traders prevent hindsight bias?

One way to minimise the impact of hindsight bias is by keeping a trading diary. A trading diary is used to record your progress, keep track of your trading, and plan and refine your strategies. You should also use it to make a note of how you feel before, during and after each trade. By writing down whether you feel confident, afraid, hopeful or uncertain, you will be better placed to get a sense of when you were successful.

By mapping the reasons behind trading decisions and comparing them to the desired outcomes, you can use your past trades to inform your future strategy. So, instead of trying to make sense of what happened by oversimplifying the reasons for past events, you can learn from the outcome.

Confirmation Bias

How can 'confirmation bias' affect traders?

Confirmation bias is the tendency for traders to search for, and put greater weight behind, information that confirms their pre-existing beliefs or predictions. This could mean that a trader disregards negative news about an asset because they believe that the good outweighs the bad – even though this may not be the case.

Confirmation bias is linked to overconfidence, which can lead to poor decision-making and overtrading. A study by Park, Bin Gu, Kumar and Raghunathan found that traders with stronger confirmation bias are likely to exhibit greater levels of overconfidence and trade more frequently. This can lead to them obtaining lower profits because they might lose more often. IG's survey revealed that 29% of traders and investors go with their gut when making decisions – a sure sign of overconfidence. ⁵

How can traders prevent confirmation bias?

Confirmation bias can be prevented by carrying out your own analysis – whether this is technical or fundamental – and trusting that it is correct, even if it clashes with earlier predictions or preconceptions.

Technical and fundamental analysis can be a great way for you to identify whether you should be buying or selling a particular asset – for example, overvalued or undervalued stock. Analysis can help confirm the true value of an asset in a more accurate and definitive way when compared to preconceived biases or gut feelings.

It could even benefit you to actively seek out information that clashes with your preconceptions because this could counteract your confirmation bias – forcing you to think about each trade in terms of its own merits.

Loss Aversion Bias

How does 'loss aversion bias' affect traders?

Loss aversion bias is a preference for avoiding losses over acquiring the equivalent gains. It implies that the fear of a loss is greater than the pleasure of a gain.

Research by Odean looked at 10,000 trading accounts held between 1987 to 1993 and found that individuals tend to hold onto losing positions for much longer than winning trades, out of a fear of realising a loss.⁶

Percentage of trades closed at a gain and loss

IG data backs this up, showing that although traders close over 50% of trades at a gain, they lose significantly more on their losing trades than they make on their winning ones. This emphasises that instead of accepting a small loss, many traders will hold on to their positions and risk eroding their profits.⁷

How can traders prevent loss aversion bias?

A key step in preventing loss aversion bias is acknowledging that it exists. When you start to create a trading plan, it’s important to consider how much you’re willing to lose as well as how much you want to gain. Once you’ve established your trading plan, it’s important that you have the discipline to stick to it to avoid taking unnecessary losses.

One way of doing this is by setting a suitable risk-to-reward ratio, which compares your capital at risk to the amount you stand to gain. For example, if you set a ratio of 1:3, then you'd only need to profit on three out of ten trades to have an overall profit. The correct risk-to-reward ratio could ensure that your gains are always at least as large as any potential losses, giving you the confidence to overcome loss aversion bias.

Gambler’s Fallacy

How can 'gambler's fallacy' affect traders?

Gambler's fallacy in trading is the tendency of an individual to think that a trade will go a certain way based on past events – even though there is no substantive evidence to support the trader's thinking. The term originated from the inclination of gamblers to think that a bet might go a certain way based on previous results.

When applied to trading, a study by Rakesh found that 55% of investors who took part believed that a random event would occur again just because it had occurred in the past⁵. This could cause a trader to base a decision on previous analysis, even when the indicators which had worked for them in the past are no longer relevant or helpful given the current market movements.

How can traders prevent gambler's fallacy?

You can minimise the risk of gambler's fallacy affecting your trading by basing your decisions on up-to-date analysis and setting a clear risk-to-reward ratio – which compares the potential loss to the potential gain for each trade you open. This can help you to think clearly and assess each situation on its own merits, and will also minimise the effects of any losses on the overall value of your trading account.

An example of a risk-to-reward ratio would be if you placed a guaranteed stop on a trade, capping your maximum loss at $100, along with a limit giving you the potential to realise a $300 profit. In this scenario, the risk-to-reward ratio would be 1:3.

With a 1:3 ratio, you could generate a profit by only being right 30% of the time. This is because if you placed ten trades risking a maximum of $100 each, you would lose $700 from your seven losses, but you would make $900 from your three gains. Of course, if you're taking on less risk for a greater potential reward, it's likely the market will have to move further in your favour to reach your maximum profit than it will to hit your maximum loss.

Footnotes:

¹Moradia, Meshkib and Mostafaei, 2012
²Tversky and Kahneman, 1974
³Kaustia, Alho and Puttonen, 2008
⁴Biais and Weber, 2008
⁵Rakesh, 2013
⁶Odean, 2002
⁷Rodriguez, 2016