Monday, December 22, 2008

Ego And Cognitive Biases.

After re-reading "Way Of The Turtle" and "Egonomics" I was reminded how important the affect the aforementioned has on trading. I thought I'd write a bit about it here to reinforce the concept in my mind, as well as spark interest in anyone who might want to look into the concepts in more detail...

Outcome Bias- How many times do we put on trades which we knew broke our rules only to find that they happen to become profitable? We then conclude that maybe we should "loosen up" on the rules...after all, we would have missed out on the profit had we had followed our rules. That's where the trouble begins! Our Egos need to be fed and are only too willing to attribute the fact that we made money to our purposeful deviation from the plan rather than ignore that win knowing it has no statistical legs to stand on.

Recency Bias- It's common to feel the affects of the recent trades we've made (positively or negatively) more than trades made a longer time ago. Again, this can interfere with the adherence to a strategy. For example, if you have a strategy that wins 60% of the time and, by chance, the last 10 trades happen to reflect that fact with 6 wins and 4 losses, the order they occur can make or break how efficiently you trade those 10 trades. Maybe the first 4 trades are which case you're likely to follow through with the plan, pumped up with confidence from the multiple wins. Maybe the first 3 trades are losses...there's a good chance trade 4 is "missed" due to hesitation based on fear. If that trade is a winner, you'll go into the next trade annoyed/angry and maybe get greedy to get back the winner you missed and, in doing so, you give back some (or all) of your can see how quickly our feelings (based on satisfying Ego) can destroy good trading plans.

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