Wednesday, October 21, 2009

Avoiding Confirmation Bias in Trading

Confirmation bias is the tendency to search for and overweight evidence that supports one's own position. This can be a major problem in trading, as it leads traders to become overconfident in their positions and stay in trades well after they should be abandoned. A simple example occurs when traders are in a position and then focus mainly on the indicators or market behavior that supports staying in the position.

In such instances, the stop loss for a position will not be a planned set of criteria. More likely, the stop loss will be pain: the position will only be abandoned when it becomes impossible to sustain a confirmation bias. Quite often, that point of pain will be an obvious point of disconfirmation, such as a break to new price highs or lows.

Trading with pain as a stop-loss is not only bad for the trading account; it makes it difficult to sustain a sense of confidence in one's work. It also leads to the kinds of frustration that can generate subsequent poor trading decisions.

When traders explicitly identify the risk and reward for each of their positions, they mentally prepare themselves for loss. In taking the threat out of normal loss, they remove much of the psychological need for confirmation bias. It is when traders feel the *need* to win that they are most likely to cling to information supporting their positions. Accepting the possibility of loss enables traders to view their positions as hypotheses: ideas that may or may not be supported by fresh market data.