Trading is a game of psychology. Understanding both the behavior of other people in the market as well as your own behavior is key to becoming a good trader. This article highlights three psychological biases that market participants often fall prey to. The first two are biases that you may unconsciously have yourself, while the third bias is often seen in retail participants (assuming you are not one of them).
1. Disposition Effect
The disposition effect is the tendency of investors to sell winning assets while keeping losing assets.
We humans value losses and gains differently. In general, the pain we feel from a loss is twice as big as the happy feeling we get from a gain. This phenomenon makes us averse to realizing losses. When holding a position that is in the red, we’d rather keep holding it than sell it. Because if we hold it, we may some day make a profit, whereas if we sell now, it means we realized a loss. We’d rather live in blissful ignorance than accept our loss and move on. This is risk-seeking behavior: rather than close our position for a certain loss, we are willing to risk losing more on the off chance of turning the loss into a gain.
Several studies (Shefrin and Statman, 1985; Weber and Camerer, 1998; Odean, 1998) have shown that this phenomenon (known as the disposition effect) is common among investors. Moreover, the reluctance to sell losers often goes hand in hand with selling winners too soon. When we are in a profit, we’d rather sell and be certain of our profit rather than risk our position turning into a loss: we become risk-averse. This again shows that the we value profits and losses in an asymmetrical manner. When our position is in profit, we become risk-averse; on the other hand, when our position is in a loss, we become risk-seeking. In other words: we expect assets to be mean-reverting in price.
This asymmetrical way of valuing our positions works against us. So, how should we value our positions? Symmetrically, i.e. assign the same weight to losers and winners? Actually, data has shown that it’s best to flip our asymmetrical way of thinking. Have you heard of the saying “Cut your losers and let your winners ride”? This is because of momentum: assets that have gone up recently may be expected to keep going up and vice versa.
2. Anchoring Heuristic
When making decisions, we are often (subconsciously) influenced by a reference point or starting point (“anchor”). This is called the anchoring effect.
Anchoring occurs everywhere. It’s often used in stores and restaurants. Suppose you pass by your local McDonald’s and want a quick snack. You initially want to buy a medium-sized Big Mac meal and see it costs $8. But then the employee mentions that for $10 you can get large meal with twice as many fries and a bigger drink. You decide to take the large meal because “it’s only $2 extra”. Congratulations, you’ve played yourself. You initially wanted the medium-sized meal but now you’ve paid $2 extra. In this case, the anchor was the price for a medium-sized meal: $8.
In trading, a common anchor is the price at which you bought an asset. Naturally, when calculating your profit/loss, you compare the current price with the price at which you bought that asset. However, checking your profit/loss often causes you to fixate on this metric and forget other factors. Often, you may hear people say things like “I’ll sell when I have doubled my money”. These people use their initial purchasing price as their anchor. Rules like these may help retail investors who don’t want to keep up-to-date with the markets, but the truth is: the market doesn’t care about you nor about the price at which you bought. So, if you’re a trader, don’t let your entry price (exclusively) determine when you should sell.
Another common anchor is the all-time high of your portfolio. You probably remember your portfolio’s ATH at the peak of the bull market. And thinking about it now probably hurts a little bit (or more). At some point, when the market is showing signs of going from a bull market to a bear market, it is important to let go of your peak net worth as an anchor. As GCR famously said:
Think to yourself: where do you see the market going in the coming months? If it’s more likely to go down and up, then it’s time to accept the fact that your portfolio likely won’t go back to its ATH soon. Once you accept this simple fact, your thinking will become clearer and it will be easier to sell your assets. Your portfolio may already be down 50%, but imagine it sinks even lower to -80%. In that case, you would have been glad you sold for a 50% loss. Better late than never.
3. Low Unit Bias
“I’m buying Shiba, it is only $0.0001! If it goes to $1 I will be up 10,000x!!!” — a rekt retail trader.
Low unit bias is more powerful than you think. So many retail investors have absolutely no notion of market cap. However, even if they do understand market cap, they may still be subject to the low unit bias.
Suppose there are two identical coins: coin A and coin Z. A-coin costs $100 and has a total supply of 1m coins, making its market cap $100m. Z-coin, however, costs only $0.01 but has a supply of 10b coins: its market cap is also $100m. Now, our friend Bob has heard of the crypto rage and also wants to invest $100 into a coin. He can choose to buy either one single A-coin or he can have 10,000 (!) Z-coins. Remember, these two coins are identical. Chances are he will buy Z-coin. If enough people do the same thing, Z-coin will eventually be worth more than A-coin. So, in this case, it’s best to follow the crowd.
For this comparison, I assumed that the two coins are identical. However, this is not even a necessary condition. What suffices is that the two coins are thought to be identical by a majority of buyers. A good example of this is Bitcoin vs Doge. Retail participants often do not know the underlying difference between these two coins: they’re both magic internet money. The only difference they see is the price. So, rather than buying 0.0025 BTC, of course they’ll buy 1,000 Dogecoins. This is part of why Doge has remained so popular, and why it will probably make a comeback in the next bull market.
Conclusion
These were three of the most common biases that affect traders, but of course there are many more. Now, just knowing about these biases does not mean you’re now immune to them. It takes a lot of practice to be able to recognize situations in which these biases may influence your thinking. And then it takes even more practice to actually act on them. When you find yourself in a situation like the ones above, make sure you think carefully before acting.
If you want to know more about such biases, make sure to check out the works of Kahneman and Tversky. Their most influential paper is Judgment under Uncertainty: Heuristics and Biases. Kahneman has also published a book called Thinking, Fast and Slow which explains many of these biases in a more approachable manner.
