Thursday, March 18, 2010

Overcoming Cognitive Biases in Trading: The Value of Behavioral Finance

A recent article on the Minyanville site does a nice job of describing some of the cognitive biases that traders experience and what they can do about those biases.

A cardinal concept from behavioral finance is that we do not process information about risk, reward, and uncertainty in a purely objective manner.

A key idea in psychology is that you are less likely to fall prey to information-processing biases if you are fully aware of those biases.

Take recency bias for example. When I was in school, I created a simple experiment: I asked people to look at the charts of stocks and predict whether the next move was going to be up or down. The charts were identical, except for the last bars. In half the cases, the last bar was up (green color); in the other half, the last bar was down (red color).

Sure enough, significantly more people thought the market was going to go down if the last bar was red than if it was green. They overweighted the last piece of data in coming to their conclusions.

This happens to traders all the time. They see the market rise, become convinced that a trend is under way, don't want to miss the move, and they jump aboard the rising market. Sure enough, that's right about the time the market is ready to reverse.

If traders are cognizant of recency bias, however, they can make a conscious effort to look beyond the last bar and fully assess buying and selling pressure, longer-term trends and patterns, etc.

Understanding the behavioral finance literature may not make you a good trader, but it can be very helpful in preventing you from becoming a bad one.