Our Inborn Biases

Let’s face it – we are all human. The purpose of our genes is to give us the best chance to create healthy offspring and pass those genes on so that the human species can continue to thrive. Over the past 10,000 years or so, not much has changed. Our genes have not adapted to the modern world too much, and they certainly have not evolved to help us deal with the turmoil that so often takes place in the financial markets. In fact, there are many deeply-rooted, biological instincts that are always working against us. As traders or investors, we can either fight these issues, or accept and work around them. Experience seems to indicate that fighting these instincts is a futile endeavor. They are just who we are. However traders and investors that have ways to work around them seem to be on to something.

So what kind of instincts and inherent traits do humans have that make it so difficult to remain rational in the markets? There are a host of cognitive biases and survival strategies that our ancestors used to survive in a much different world. Those are still with us. We will take a look at what they are and what we can do to neutralize their effects on our decision-making.

Let’s say you have the option of getting $900 with a 100% chance or $1,000 with a 90% chance. Which do you choose? If you are like most, you will choose to take the 100% chance of getting $900. However as humans we are very immune to taking losses and admitting defeat. When we consider the alternative problem, we can see this: Would you rather lose $900 for sure or take a 90% chance of losing $1,000? Most people will take the risk instead of certain defeat. This bias is referred to as loss aversion and we are wired to think that way. However this type of thinking gets us into trouble when dealing with the financial markets. What we should be doing as invesors is just the opposite: cutting the loss (losing the $900 with certainty) and riding the winner (take that 90% chance of making $1,000).

Another major bias we have to deal with is the hindsight bias. It is easy to look at a chart of a company’s stock and think that picking the highs and lows would have been pretty easy. After the fact, it looks like that was the only possible course of action. The same can be said about history. We are always looking for cause and effect even when there is none. Our brains are wired to create narratives. So while it is very easy to look at what has happened in the past and assume that it would have been easy to predict at the same time, you need to be aware of the fact that hindsight really is 20/20.

Let’s say you bought XYZ stock at $50. It trades down to $49, $48.50, $48. What might you be thinking at this point? If you are like most investors, you are not thinking about cutting this loss and moving on. Instead you are looking for reasons that you are still right. So you may interpret patterns on the chart or small moves up as being signs of a bottom. This is referred to as confirmation bias: your brain is scanning for all information that reinforces what you already believe. It is the opposite of having an open-mind and being able to adapt to new information.

In addition to these biases, we also have the tendency to see order where there is none. We might see patterns in random market behavior. This is similar to the hinsight bias in that we are manufacturing narrtives. A good deal of the price action that takes place in the markets may be purely random noise. It is important to recognize it as such and not get too caught up in making impulsive decisions. However it is worth noting that being able to recognize randomess and real, useable market data is what will seperate a good and a bad investor.

So while we may all come equipped with some of these biases that served our ancestors well, they are harmful to us in making decisions in the financial markets. They are deeply rooted in our biology and I don’t think there is much you can do to fight them. Instead, recognize and appreciate the fact that it is just part of being human, and work around them.
Great insight - thank you LisaErd! What techniques are there to help us address these biases and issues? Techniques to recognize that we're doing this and techniques to stop us from doing this...

I recently read The Power of Habit and it gave a brief helper on how to address bad habits at the end of the book but I find that difficult to translate into actionable steps in this example.

Does anybody else have any ideas?

Disclaimer: Although I've never met LisaErd in person we have chatted and emailed each other over the last ten years. She and her husband were both pit traders in Chicago for many years. I have great respect for her opinion and insight.
Outstanding post LisaRrd thanks! I have The Power Habit & several other head/mental books, they are helpful to a point & do increase awareness, but it's still hard to take the steps one needs to function as an emotionless machine. Mental rehearsal & deep breathing seem to work for me. I think of a setup as a cue, a trade as a routine, the exit as reward. I sit here eyes closed breathing deep, exhaling slowly & mentally rehearse cue, routine, reward in my head, it seems to help. After reading LisaErd's post I'd say that is my way of working around some of my problems.. I have a distraction problem I've been struggling with for years, I've keep a log of how many trades I miss because of my lack of focus, it hasn't helped much but it makes me feel like I'm trying.
Someone that I trust sent me this link which relates to this topic and says that most of the meat of the presentation is from 23 - 45 mins on the video and the rest is just "stuff." Let me know what you think.

Great article and perspective - you are dead on!!

Without hesitation I can say that fear, greed and emotion are the biggest killers
in trading your own account.

Admin Edit: Spam portion of this post deleted.
Some fellow banged out a psych gig of how to approach trading. Thought I'd post it. Don't agree with all of it, but it's a real sharing from a real trader that made money. Maybe there's some insight in the words and topics that dovetail with earlier posts.

Click link to access uploaded file:
Psych Discipline Packet6.doc

A Funky Monkey take on the overall trading gig!
Just in case anyone is wondering, MonkeyMeat has the author's explicit permission to post this here.