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Trading Lessons: The Danger of Outcome Bias

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By any name, this tendency can play havoc with your trading.

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Dear Professor Sadana,

When you wrote about "ownership bias," it was as if you wrote about me. I realized I had been holding stocks because I own them already and not for their merit. I'm sure homeowners have experienced this bias the most while pricing their homes. Are there any other "biases" that I need to fix?

-Minyan James



Dear Minyan James,

To answer your question, let me walk you through a recent possible-trade set up that I encountered.

Below is a chart of Jos. A. Bank (JOSB), which was flagged as a short in my chart-scans a couple of days ago, when it broke the triage of 10-20 and 50-day moving average. I expected it to go to previous lows (35.8) and any failure to hold it would trigger a possible double top formation and make the $30 target very attractive.


Click here to enlarge.


However, there was one caveat: Check out the number of consecutive down days; something that I couldn't see for the past few months. So while it didn't mean that the stock won't go down, it could mean that the stock might have some respite from selling and have an up-day -- and that's when I decided to short it.

Well, there was no respite. The stock just went lower 8 days in a row and is currently trading at $33. And of course, I could fret and fume (and I did); the reality is that I chose to not trade it, at that point, for reasons mentioned above.

And there you have yet another bias: "outcome bias." In the words of Curtis Faith, in The Way of the Turtle: "Outcome bias is the propensity to judge a decision by its outcome rather than by the quality of the decision at the time it was made."

This book is a couple of years old, but those of us who've been doing this for any amount of time are very well acquainted with this propensity (as I said yesterday, I've seen many smart people lose a lot -- even in brand-name companies like General Electric (GE) AIG (AIG), Intel (INTC), Cisco (CSCO) and others -- as they got sucked into the vortex of their own beliefs and analyses -- and disregarded reality.)

And outcome bias can play havoc with future trading: I might get so caught up in fuming that I might still go ahead and place the trade, only to see it reverse. Or I might miss other trading opportunities. We face this every day, and, as an active trader, I can attest it's certainly not easy to deal with.

So, I try to take inspiration from Yogi Berra's quote and move on

"I never blame myself when I'm not hitting. I just blame the bat, and if it keeps up, I change bats. After all, if I know it isn't my fault that I'm not hitting, how can I get mad at myself?"

There are many other such biases and ensuing trades; I like to name them for identification purposes (for the same reason they name hurricanes).

And Minyan James, while you're at it, why not pose such an open-ended question to the woman in your life!
No positions in stocks mentioned.

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