How to Overcome Cognitive Biases in Trading // Ep. 24 - Think Profit Podcast (2024)

In This Episode

• Why some traders always avoid certain pairs
• How mental shortcuts can burn you
• Trading is not a natural activity, so cognitive biases tend to harm

We Talk About Mindset Biases and How to Overcome Them

We all have biases for or against things in life.

That's natural.

These cognitive biases help us navigate the world successfully because they are shortcuts that allow us to process a lot of information very quickly. But in trading, they can hurt us.

In this episode, we talk about the different types of biases that traders have and the best ways to overcome them.

Read The Transcript:

Hugh: Hi Walter. Let’s talk about cognitive biases in trading. How does it affect people? Where do they come from and how can we mitigate the bad ones?

Walter: From my point of view, it’s funny you know, I think because I went to school and did the whole thing with the Psychology PhD. It doesn’t really matter the field that you are in, you always kind of feel like you know better.

Let’s say, you are a heart Surgeon. You probably always think that you know the exact best thing to do for your heart. The reality is, when we look back like fifty or a hundred years and people are going to go, “I can’t believe we are doing that to people’s heart” do you know what I mean?

Hugh: Exactly.

Walter: Definitely the same with Psychology. The problem with Psychology, two problems: one is it’s really a new science and it is hard to measure people. Two is, everybody has their own theories about what is really going on when it comes to Psychology. So you kind of have to fight through that.

When you talk about cognitive biases, what I think of are mental shortcuts. Cognitive Psychology is called the heuristics. The example that I’ve had in high school is this: There's two guys that walked in — this is so funny — there’s two guys that walked into the classroom.

You’re in high school; you’re standing there in high school and there’s two guys who walked in. There’s a short guy who is about five, two and he is wearing a suit. It looks like he is about forty-five years old and then there’s a really tall guy who looks like he is about twenty-three, really tall and he’s like six, nine.

Your teacher says, “We are going to have an NBA player come in and his agent and they are going to talk about being a Professional Player.” Then, you hear the short guy say, “Alright now, when I got into the NBA”. It is funny because obviously everyone assumes that the young, tall guy is the player; that is how our cognitive biases work.

They enable us to navigate through life without having to look at every situation and go, “Okay, this is new. What do I do?” Like that first day at work or that first day at school or whatever where you just do not know what to do. In that sense, they’re very useful.

People say, “I’m not prejudiced”. Everybody is prejudiced. Everybody has ideas about what something is before they actually know what it is. Fear is the big one. When you are scared of something, when you don’t really know what was put into a box; some people get really anxious.

So what I would say about cognitive biases is that they help us in everyday life. The problem is, when it comes to trading because trading sessions are unusual, unnatural things that humans haven’t been doing for hundreds and thousands of years; we haven’t really gotten to the point where we have cognitive biases that suit the behavior of trading.

When you think about it, I mean people say, “Oh, just buy low and sell high. That is what trading is.” Sure. How do social proof work into that? If you fire up Twitter right now, you are going to find hoards of people who are showing you how much of a genius they are because they are trading the stock market, and everyday they make money in the stock market because it only goes up.

Since we recorded this, after March 2020 pretty much the stock market is gone just about straight up. You see all of these people; you see that’s the kind of thing like social proof is a big one. If I have a list and say social proof is a big one. Social proof is this idea that if it works for other people, it will work for me. If my Uncle Joe who knows nothing about the stock market can trade these stocks and make money every single week then I can do it.

Hugh: Hey there! I hope you find this episode useful. I just want to let you know that Walter and I give away something valuable every month that helps traders improve their skills. You can enter to win by simply leaving an iTunes review and leaving a comment on our YouTube videos.

At the end of each month, we'll look at the comments and reviews from the month and we'll pick a winner at random. Each comment and each review counts for one entry during the month that it's pitted.

So, if you're interested in that, be sure to enter after this podcast is over. Alright, back to the episode.

Walter: So that’s a big one right there. Another one is confirmation bias which is huge for technical traders because we think we have a system; you throw up all the indicators or whatever you are using on the chart. And then, you go back and you look. You say, “Wow! This works really well.”

What you’re doing is you are skipping over the losing trades. You are just looking at the big wins. We’ve all done it. So if you don’t do your back ​testing, you don’t catch the losing trades; that is why simulated back testing is so important. So that’s another one, will be confirmation bias.

Another one, you see this a lot when they try to get you into a mortgage. A mortgage is like they’ll do this thing and they go, “Okay, if you get a mortgage with us, the first couple of years are going to be really low interest rate and then maybe we can even give you a cash bonus.”

Or, if you buy a car that you would want too. “If you buy a car, we’ll give two grand; just cash for buying the car.” They have these really low interest rates and then it kicks up later on in the loan. Saving with life insurance or whatever where you start off on this really low premium and then as you get older, it really ramps up.

Actually, when I got life insurance I did the opposite. I said, “No, I want life insurance like I pay the same amount from now until I’m eighty”. So they charge you more per month but it’s actually evens out better for me if I live long.

Hugh: They do the term-thing, right? They try to say the term life insurance?

Walter: Exactly. You want to have it now and you want it all now, that sort of thing. Recency bias, that’s another one. So you go, Hugh tells me, “I betray this MACD strategy and it just keeps losing. It’s been losing for the last three weeks” then I’ll say, “Hugh, have you looked at what it was like nine months before that? Oh, it’s fine. Makes tons of money.” Recency bias is something that is favored now because you’ve had three weeks of losers.

That’s interesting about humans; humans aren’t happy. If you think about it, a lot of other species they’re pretty happy like a beaver learns to make a dam. The beavers like, “Dam works pretty good. I think we’ll keep using it” all the beavers in the future, they all make the dam the same way. The dam all looks the same.

Humans are like our cars, they look nothing like the model thing. We’re always trying to improve things; it is part of who we are. You have to fight that if you are a technical trader.

You spent all this time building the strategy and then all of a sudden if you have a few losing weeks you are like, “Shoot, I’ve had three losing weeks. It is time to go tinkle with the strategy”. That is kind of the way we’re built. You can look them up; we can put in the link there. I’m sure you have some that you struggle with, that you’ve thought about in terms of your trading.

Hugh: Yeah. I think one of them that I see a lot is kind of like tweak on the last of what you’re talking about; it’s like a burned bias. Maybe you’re starting out and then you lost your first two accounts on the JPY/USD and then you are like, “Oh, that pair sucks.”

But then you didn’t test it on any other strategy and then for the rest of your career you’re saying, “I’m not trading the JPY/USD because it sucks. I just can’t figure it out”. I think that’s a pretty big one that I see in some people.

Walter: Or they want to make it back, they get revenge. “Oh, I’m going to get back on the Swissie. I’m going to get that Swissie.”

Hugh: That is the biggest one I see. I think you’ve covered the other one that I’ve experienced also but those are some major cognitive biases. Getting over them I mean, we’ve talked about all these other strategies of getting over them but I think it really comes out on reviewing.

Reviewing what you are doing. Asking yourself: is this a cognitive bias or is this a rational bias that I have to this? Or, is it something that I had a past experience that’s not certain in several years, something like that.

Walter: You have your journal. I hate to use this term because everybody uses it nowadays but mindfulness is a big one. It’s such an in thing right now but if you can be mindful and aware like self-awareness is a big deal for traders; just having that gives you a leg up like being sort of a data-driven and self aware.

If you can do those, have those two things you are in a good spot. Just knowing like, “Okay, hold on. I’m doing this again. I’m revenge trading” that sort of thing. My big one when I started out was moving my stop loss. “Wait, hold on.” I’m moving my stop loss again.

What am I scared of? I should be scared of not following my rules rather than being scared of taking a loss because eventually I’d take the huge loss when I keep moving my stop like that. Giving the trade more room.

Hyperbolic discounting; that is the one I wanted to and I forgot about it. I just want to talk about this one. This is the idea and this is why for a lot of traders, trailing exits or big targets are hard because of hyperbolic discounting.

For example, I’ve got a trade right now on the Swissie. It’s gone for weeks and the Swissie as of this recording has doubled mad. So it would be really fun to cash out that trade right now. There’s so many things I could do with the profit but I’m not going to do it because I’ve got to stick to my rules. I’ve let the trailing exit finally pop me out.

So hyperbolic discounting is like, I have this much money right now. I can take it right now; it’s in my hand. I can see them in my account; hit the button, trade over cash. Or, I can wait and I don’t know what is going to happen. Am I going to give back some of the profits that I have right now or is the market going to give me even more profit? I have no idea.

Now the Swissie it keeps giving over the last couple of weeks. Actually, it’s the end of the month now as we’re recording this and I took it like the sixth or the seven. So it’s basically been a month of holding on to this trade; beginning I didn’t do anything, just chop around.

Finally, it started flowing for me and so it is super tempting to do that but I am not going to do it. I’m just going to let the trailing exit, that is why I like to automate the trailing exit; that is really a good thing to do for people who have this problem of cashing out too early.

Just like you say, “I know I shouldn’t do it but I keep cashing out too early.” Try to automate your exits; that’s a really cool way then you’ll just babysit the EA and make sure that it gets you out. So that’s another one, hyperbolic discounting.

I did the thing, I know we’ve done this exercise with traders; I think you were there. Almost always I go, I have two envelopes, right? We did it with Caroline and I said, “In one of these envelopes is fifty bucks and it’s yours. Take it; if you open it up, you get the fifty bucks” or hundred bucks or whatever it is because I can’t remember.

And then I say, “Now I’ve got another envelope here that you can switch but this envelope has either nothing in it or two hundred bucks” I can’t remember which; I don’t know. You offer them the opportunity.Every single time I’ve done that, people would always keep the envelope; they never do the switch.

The only one that did it was Caroline and that’s because we kind of convinced that she should.You were there too; that was pretty funny because I’m telling you every single time I’ve done it, sometimes I put the extra money in the envelope and sometimes I don’t so it’s not always that the extra money is in there.

So, it is really interesting because that’s the best way I know to highlight this hyperbolic discounting. It is worth more in your hands than the potential of even more in the future; that is basically it. That is why trailing exits are so hard for us traders to follow because of that bias.

Hugh: Yeah, for sure. Why do you think that is?

Walter: I think if you were to take it at evolution in front of you and say, “Okay, Irk the caveman is cruising through the woods. He sees a bushel of berries here; he stops and picks the berries.”Eat the berries and collect the berries or should he keep walking, maybe there’ll be a pineapple tree. He likes pineapple; even better if it can feed his tribe or whatever.

So it makes sense that you would take it while you have it. We spent a lot of time as hunter gatherers just looking for food. Once we found food, we could relax and all that but then you know the next day you’ve got to find more food.

So that's why all these intermittent-fasting-thing is over aged. People are saying that is how we always eat. When you are a hunter gatherer you don’t eat it all down at noon or at lunch it does not happen that way. You don’t know when you’re going to run into another rabbit or bushel of berries.

I think if you were to take a socio-biological point of view you would say, “Well, we kind of learn to survive by taking it when we can.” We would apply that to money too, I guess.

With all the economic theory stuff, if people who have business background and they’re going to economic theory, they act like people irrational and do the weighing saying, “Oh yeah, this is what’s this and the chances of me getting you know” that’s all BS. It is driven by cognitive bias as you and I know because we’re faced with theses everyday. It’s crazy.

Hugh: Yeah, it is crazy. You kind of rewrite in trading.

Walter: Exactly. You rewrite your brain, that’s exactly it.

Hugh: Cool. Thanks, Walter.

Walter: See you.

Hugh: All the information in this podcast is for educational and informational purposes only and is not trading or investment advice.

Enter the Monthly Contest

We give away a trading prize every month, so be sure to enter to win.

You can win by doing one or more of the following:

• Leave a comment onYouTube
• Leave a review oniTunes

Each action counts for one entry in the month that it was posted. We will pick a winner at random from the entries that month.

The giveaways can include books, coaching sessions, trading tools, orsurprisegifts.

It will usually be something that will help you improve your trading psychology.

Listen to the Audio Version

Click the play button below to hear the audio-only version. You can also download the mp3 file below.

How to Get New Episodes of The Think Profit Podcast

You can get notified of new episodes of the podcast by subscribing to ouremail list, or subscribing via any of the major podcast platforms that can be foundhere.

If you enjoyed this episode, a 5-star review on your favorite podcast platform is always greatly appreciated!

Thanks for listening and we hope that your trading is going well!