Trading Psychology: 6 behavioural biases that create pitfalls for investors – and how to avoid them
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Being a good investor requires a disciplined research approach; you won’t get far unless you can unpack a set of financial statements or understand the broader trends in a particular industry.
But undoubtedly, psychology also plays a key role.
“The stock market is a device for transferring money from the impatient to the patient,” legendary investor Warren Buffett once said.
And while patience is a virtue, new research from world-leading online trading provider IG Markets illustrates investors are susceptible to many less virtuous mental patterns that increase the risk of subpar returns.
IG’s analysis covers four key aspects of trading psychology – behavioural biases, personality traits, factors that affect moods & emotions, and social pressures.
And it forms one component of a series of market-leading pieces of research by the IG Markets data team – insights which could help the 195,000 clients that use its trading products.
In this series, we take a closer look at the six behavioural biases that IG Markets has identified investors can be prone to (sometimes without even realising).
In almost any pursuit, most people would be familiar with the temptation to take the easy way out. And in investing, that habit can manifest itself in availability bias – the tendency to base investment decisions on the most readily available information.
Let’s say for research purposes, an investor places an over-reliance on optimistic company forecasts without doing due diligence on financial statements and real cash flows. The bias tendency can also be anecdotal; say a friend or colleague got burned on an investment, so you make the decision to avoid it based on their experience.
A good way to avoid availability bias is to remember that if making money from investing was easy, everyone would do it. It’s important to build good research habits so when you do pull the trigger on a trade, you can at least be confident that the decision was based on sound evidence that fits your investment criteria.
This psychological error occurs when investors incorrectly use a given piece of information as a frame of reference, or ‘anchor point’. Often, it then skews their perception of a how a given investment should perform in the future.
Consider the red-hot buy now, pay later (BNPL) sector on the ASX, which posted an average return of well over 100 per cent in 2019. Looking ahead, an investor prone to anchoring bias may view anything below that as a poor result.
As with availability bias, getting the right anchor point often comes down to doing the work – carrying out extra research and analysis so that you can take a confident view of prospective returns for a given stock or sector, and whether that suits your investment goals.
A classic in the field of psychology, confirmation bias is often cited as one of the most common trading pitfalls. And it’s not just investing – it often serves to cloud human judgment in other fields such as science and politics.
It occurs when investors put more emphasis on information relating to a stock or investment idea that confirms their pre-existing beliefs. Confirmation bias typically leads to over-confidence, and can leave an investor prone to ignoring bad news about a given company – for example, if they are already convinced its stock price is poised for a 10x return.
Avoiding confirmation bias starts with an awareness that the human brain has a tendency to trick itself; to double down on matters where its mind is already made up.
Using that awareness as a basis for decision making, investors will be find it easier to keep an open mind and be willing to change their view as new information comes to light.
As the name suggests, this refers to a tendency among gamblers to place an over-reliance on past events as the basis for their next bet. And it’s the basis of a well-worn phrase in investment circles; “past performance is not indicative of future returns”.
Studies indicate that a majority of investors lean towards trades that have worked in the past, even if current market dynamics create a much lower probability of success.
Traders can avoid this pitfall by analysing historical data to understand why a given stock investment worked well in the past. But just as importantly, they need to combine that analysis with an assessment of current events to see if the conditions are still in place for those patterns to repeat.
We’ve probably all been guilty of this in one form or another; when an unexpected event takes place and we say something like “I could’ve told you that was going to happen”.
Unfortunately, in investing, things are rarely that simple. While the causes of 2008’s global financial crisis have now been dissected and analysed to the Nth degree, very few investors had the foresight to see that such a huge correction was imminent.
One strategy that investors use to alleviate hindsight bias is a trading diary. And not just a list of trades by date, but a detailed summary of the rationale behind each trade and how you felt before and after each trade. Monitoring those emotions can help you to avoid falling back into unproductive mental patterns.
A well-known psychological phenomenon when it comes to investing is that people often experience much stronger (negative) emotions when they lose money, compared to when they make it.
That can manifest itself in a few ways – firstly by creating an overly conservative mindset and missing out on potential opportunities. In addition, studies indicate that investors have a tendency to hold onto losing trades, exacerbating losses when they do go to sell.
And data insights gleaned from millions of trades on the IG Markets platform backs that thesis up. The numbers show while the majority of trades on the platform are closed at a gain, financial losses on losing trades are higher than the per-trade gains on winning ones.
A simple way to try and avoid loss aversion bias is to establish rules that suit your temperament and experience. This can include setting return targets and win/loss ratios, as well as deciding when you will exit each trade.
For more information on behavioural biases and the psychology of trading, visit IG Markets’ interactive psychology in trading research here.