Last time, we discussed three cognitive biases that can affect traders: the disposition effect, anchoring heuristic, and low unit bias. Such psychological biases affect everyone, not just traders. However, the price traders pay for falling prey to them is much higher than for others.
That is why it is important for traders to know these biases and be able to recognize them in their own behavior and that of other market participants. Trading is, after all, a game of psychology. These cognitive biases are ingrained deeply in our brains as a result of evolution. They were useful for our ancestors living in the wild, but not so much for traders sitting in front of a screen all day trying to predict prices. Today, we will discuss the status quo bias, confirmation bias, and the overconfidence effect.
1. Status quo bias
Status quo bias is defined by a preference for the maintenance of one’s current state of affairs (the status quo), even when it is suboptimal.
The status quo bias ties in with some other cognitive biases such as confirmation bias and sunk cost fallacy. Status quo bias explains why HODLing is such a widely seen phenomenon. When your investment/coin is going down, you often prefer to do nothing and keep holding, hoping that it will go up again. In other words: you expect the price to mean-revert. This is a dangerous assumption, especially if it may be the beginning of a bear market.
Status quo bias is also seen in traders that have losing strategies. Rather than examining why their strategies are losing recently, they would rather just stick to them. After all, they have worked in the past, right? However, it is important to realize that certain strategies won’t work forever. In such cases, one must adapt to the changing characteristics of the market.
Example: a bear market conditions you to short pumps that don’t have much substance because, if you wait a bit, the coin will go down again. However, when the market is in a bull run, this strategy can be very dangerous. You (and others) may expect a pump to retrace only for it to go higher due to a short squeeze. In such cases, it is important for a trader to adapt and not get stuck in old beliefs.
2. Confirmation bias
Confirmation bias is the tendency to search for, interpret, favor, and recall information in a way that confirms or supports one’s prior beliefs or values.
Confirmation bias is one of the strongest human biases. It affects people in many aspects of life: politics, religion, relationships, and, of course, trading. Why is it so strong? Because we do not like our beliefs to be challenged. We do not want to think that our beliefs have been wrong for a long time. In areas like politics or relationships, these beliefs or ideas have become part of our identity, making it even harder to let go of them. This happens less with trading, unless you make your trading ideas public (the reason why I do not often share trades).
When we formulate a trading thesis, such as “BTC will go to $12k”, we are susceptible to giving too much weight to information that supports our thesis, and too little weight to information that denies it. For example, even if BTC goes from $15k to $30k, we may see every pump as a bull trap, thus confirming our thesis, while we ignore other relevant facts.
If you want to overcome confirmation bias, you have to look in the mirror and be completely honest with yourself. In the case of trading, try to look at your trading idea from both perspectives at all times. To go a step further, try your best to undermine your trading thesis. Try to come up with as many arguments against it as you can. This will help you take a more objective view.
Confirmation bias also ties in with the status quo bias. You are looking for information that confirms your ideas because you like the status quo, it’s comfortable, you don’t want to change things.
3. Overconfidence effect
The overconfidence effect is a bias in which a person’s subjective confidence in their judgments is reliably greater than the objective accuracy of those judgments, especially when confidence is relatively high.
Overconfidence affects us all. You’re on a winning streak, having made some good trades in the past week, so you decide to size up for your next trade. You formulate a thesis, enter the trade, and wait for the market to do its thing. But… the market goes the other way? What is going on? Surely you must be right and the market is wrong. You wait and wait and wait… In the end you can’t bear it anymore and cut the position, leading to a big loss. The market has gotten the better of you.
That is the overconfidence effect at play. Overconfidence causes traders taking more risk and making suboptimal decisions. It is caused by the illusion that one understands the markets, and it often occurs after a trader is on a winning streak. The trader thinks the winning streak is entirely due to his great trading skills and forgets other factors such as and randomness. After all, if a coin lands on heads 5 times in a row, that doesn’t mean the probability it will land heads again is increased.
Overconfidence can be lethal in trading. If you let it get the better of you, you’re done for. Always remember that you can only predict the market up to a certain point, there is always a certain probability that the market doesn’t follow your thesis, however well thought-out it may be.
Conclusion
Trading is all about psychology. Over many years, our brains have evolved to inhibit certain biases. It is very hard to stay rational at all times and overcome these biases. You will very likely fall prey to these biases from time to time even if you know about them; that is how strong they are. Thus, your goal should be to decrease the frequency at which they occur, because eliminating the biases altogether is unrealistic.
For more information about cognitive biases, you can read this Wikipedia page, or of course ask your friendly neighborhood ChatGPT.
