Sorry!! The article you are trying to read is not available now.
Thank you very much;
you're only a step away from
downloading your reports.

12 Cognitive Biases That Endanger Investors

By

What you don't know can impact performance.

PrintPRINT
Editor's Note: Todd posts his vibes in real time each day on our Buzz & Banter.

I recently came across a terrific article that addressed 12 cognitive biases that prevent human beings from behaving rationally. As perception is reality in the financial markets, I thought it might be useful to address those issues through the lens of a trader.

1. Confirmation Bias

This is a fatal flaw of trading; we tend to surround ourselves with information that validates our own point of view and dismiss input that conflicts with our reasoning (also known as cognitive dissonance). This is the primary reason why we always strive to see "both sides of every trade" as the residual grist between variant views is where education-and profitability-resides.

2. In-Group Bias

This is a manifestation of confirmation bias, or the tendency to surround ourselves with those who share similar takes on the tape. This could pertain to our physical environment or a virtual experience, such as Twitter. Not only does this provide a false sense of security in our individual viewpoints, it makes us suspicious-or angry-with outsiders who dare to question how we feel. (See also: The Gold Scold.)

3. Gambler's Fallacy

One of the most famous disclaimers in finance is that past performance is no guarantee of future results. This bias is often referred to as a "glitch" in our thinking in that it extrapolates what happened in the past to construct an idea of what will happen the future. How many of you have played roulette at a casino under the premise that a string of red increases the likelihood of a black outcome? That's flawed thinking; the odds of red (or black, for that matter) or 48% on each independent spin.

4. Post-Purchase Rationalization

One of our Ten Trading Commandments is that the definition of an investment should never be a trade gone awry. Nobody initiates market exposure expecting to lose money, but we should never post-rationalize our risk (such as ignoring stop-losses or throwing good money after bad). We would be wise to remember that good traders know how to make money but great traders know how to take a loss.

5. Neglecting Probability

History is littered with stretches where in hindsight we're reminded not to confuse brains with a bull market. This bias limits our ability to properly assess risk, whether it's overstating an unlikely event (such as buying a stock for a takeover) or understating an unlikely event (such as Y2K, the fiscal cliff, or a terrorist attack). Tail events do happen, of course, but betting on an outlier is a long shot by its very definition.

6. Observational Selection Bias

This is when we suddenly notice something we haven't noticed before, and wrongly assume the frequency has increased (when it hasn't). Let's say I bought cannabis stocks as a way to play (what I perceive to be) the legalization of marijuana. All of a sudden, everywhere I look, there are more and more signs that support my thesis; the topic is featured on 60 Minutes, it's a hot-button issue during the election, it gained momentum in the mainstream media. While some of that may prove true, I am on the lookout for news, whether it's conscious or not.
< Previous
No positions in stocks mentioned.

Todd Harrison is the founder and Chief Executive Officer of Minyanville. Prior to his current role, Mr. Harrison was President and head trader at a $400 million dollar New York-based hedge fund. Todd welcomes your comments and/or feedback at todd@minyanville.com.

The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

Copyright 2011 Minyanville Media, Inc. All Rights Reserved.

PrintPRINT
 
Featured Videos

WHAT'S POPULAR IN THE VILLE