Cognitive Biases

We all have a tendency to think we are right most of the time, even when we are wrong.
This is caused by what is known in psychology as “cognitive biases”, and it often results in bad trading decisions, which over time results in losing money.

So what is a “cognitive bias”?

A cognitive bias is a systematic tendency that leads our thinking away from a correct judgment.
There are about 50 different cognitive biases that have been found over the last 50 years by psychologists and behavioral economists.

Now let’s try to explain in simple terms why we are prone to those cognitive biases and which ones are most relevant to our decision-making.

 
The Mental Harmony Puzzle

Dr. Chaehan So depicted the cognitive trap we tend to fall into when making a judgment as the Mental Harmony Puzzle.

Here is how it works:

1. We start with a thought, which is like the picture of a puzzle, which becomes the picture in our mind.

2. When we’re building the puzzle, this picture in our mind serves as a reference for us to build the puzzle. For any information coming in, we check if it fits into the picture. If it does fit, we put it into the puzzle. If it doesn’t fit into the picture, we throw it away. And as long as we follow this process, our mind feels in harmony.

3. We are building this puzzle not only with our consciousness, but also with our unconsciousness, with us being unaware of the process of “selective perception“. Selective perception filters all information according to the picture in our mind, so we can see and hear only that information that fits into the picture. So even if we started with a wrong picture, we would still see and hear that information that tells us: “I was right”. So we wouldn’t even realize that we end up with the wrong judgment. This is the trap of the Mental Harmony Puzzle.

“Selective perception filters all information according to the picture in our mind, so we can see and hear only that information that fits into the picture”

 
Three of the Main Cognitive Biases That Impair Our Good Judgment

Here is a story about a fictional trader, Joe, whom I think we can all relate to:

1- The Confirmation Bias

Joe sees a stock trending on social media. The stock XYZ, which already went up 200% from $1.5 to $4.5 in just a couple of weeks, jumped another 20% to $5.4 as the company announced the new drug they are currently testing is showing great promise.

Joe recalls this company being mentioned on CNBC a couple of days ago. He “googles” the company and looks for articles that would suggest the stock might keep on increasing in price. He finds some articles confirming that the company’s new drug will be a blockbuster worth billions of dollars. He reads all the positive comments about that company on different social media platforms.
He then looks at the chart and although the stock doesn’t fit his technical entry criteria and may be extended, he reasons that since analysts target is $15 and the stock was trading around $20 a few months ago, the stock is likely to at least triple from here.

All excited, he remembers that George Soros’ quote “When you have tremendous conviction on a trade, you have to go for the jugular“. He puts 50% of all his savings in XYZ, posts on social media that XYZ is a sure winner, and starts thinking about the things he will buy with his winnings.

This is the confirmation bias: a systematic tendency to actively seek only information that confirms our beliefs, and we reject or disregard information that disconfirms our beliefs.

2- The Self-Serving Bias

Later on, the trade actually goes against Joe. He now not only is at a loss, but the stock keeps on moving even more against him.
Joe is just baffled. How can this trade not go as anticipated? How can his thesis be wrong?
He rationalizes that his reasoning is still correct. After all, he did some research, and CNBC and social media confirmed his view. He is not wrong. Sellers are just incredibly stupid and are selling the opportunity of a lifetime. On top of that, the stock is probably being manipulated by unscrupulous people wanting to buy some more shares at a lower price. He knows the stock will recover as soon as the market finally understands how company XYZ will be worth billions in the near future.
He defends his position actively on social media.

Unconsciously, “selective perception” is at play here. Joe can only see information that fits into the puzzle he has in his mind, regardless of whether the puzzle is correct or not.

This is the self-serving bias: a systematic tendency to focus our attention on the information that enhances our self-esteem and protects us from any negative feedback.

Both the confirmation bias and self-serving bias have similar underlying psychological mechanisms. The difference is that with the confirmation bias, we are building a puzzle of any picture of any kind of belief, whereas with the self-serving bias, we are building a puzzle of a picture of ourselves.

3- The Hindsight Bias

The stock fell back to $2 and Joe is now under on this position by almost -63% and his total trading capital has now shrunk by -31.5%.
Unable to withstand the pain of that loss anymore, he finally decides throw in the towel and exits his position.

Joe now reflects about what happened and how he got into that situation. He starts to recall all the red flags he noticed before entering the stock. He remembers he saw many articles saying the company’s drug was not ready yet and the chances it got approved were slim. He also knew that most biotechnology stocks were just scams, just as many people were saying on social media. And on top of that, the stock was clearly extended when he entered the trade.
After thinking about it, it was now clear in Joe’s mind that he knew this trade was going to be a loser right from the start.

This is the hindsight bias: a systematic tendency to represent the past not according to what we experienced, but according to what happened later.

 
=> The confirmation bias confirms our initial belief. The self-serving bias enhances our self-esteem. And the hindsight bias changes our memory of the past.
They have something in common. They are based on our mind wanting to preserve our beliefs, so it can feel in mental harmony.

But we have to fight this harmony, because it triggers “selective perception”, which makes our mind miss all the contradicting information.
In case we started with a wrong picture, the contradicting information could help us change our wrong picture into a right one.

 
How to Make Better Decisions?

Here are 3 suggestions that could help you make better trading decisions :

1- Fight the first impression

Studies have shown that we form our first impression of a person in the first milliseconds, which is faster than the blink of an eye. We basically form our first impression before our first conscious thought about a person.
Before our first conscious thought, we already have a picture in our mind. And we are very reluctant to change this picture.
So constantly remind yourself that you are unaware of your first impression, that you may already have a biased opinion on a possible trade for instance.
If you do that, you are ready for recommendation #2

2- Jump to the other side

Once you know that you already have a pre-built picture in your mind, you can explore the other side of the picture. Search for the opposite view, for arguments against your view on a particular trade, for articles against that company you want to go long the stock, … You will then have the whole picture and will be able to make better informed decisions.

3- Delegate your decision-making to checklists

Instead of being constantly faced with discretionary decisions, you can write down your trading strategy and create checklists based on it.
You need an entry checklist and an exit checklist.
Before taking any trade, go through your entry checklist: if not all the entry checklist items are met, simply do NOT enter the trade.
Before exiting any trade, go through your exit checklist: if the exit checklist items are not met, just stay in your position.

 
 
(This post contains content from Dr. Chaehan So’s TED Talk, “Why we are wrong when we think we are right”)

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