Friday, July 18, 2014

The Bias Blind Spots of Investors and Traders

Surveying the literature on the behavioral biases of investors, it does indeed seem as though the model of infinite stupidity is closer to the truth than the model of rational market participants!  The list of such biases is impressively long: Barry Ritholtz offers this list; see also this overview from Morgan Housel and this particularly thorough list from the Psy-Fi Blog.  Abnormal Returns highlights the problems associated with positive thinking; Stammers focuses on 3 biases that impact investments; and Above the Market offers this summary of biases.

A very interesting study from the University of Pennsylvania finds that neither investor sophistication nor investor experience, by themselves, is sufficient to overcome the behavioral bias known as the disposition effect.  This is a bias to sell winning investments and hold onto losing ones.  Investors who are both sophisticated (knowledgeable) and experienced are able to sell losing investments appropriately, but they still display a tendency to prematurely sell winners.  

This phenomenon, known as the bias blind spot, reflects the fact that knowing about biases does not prevent people from falling prey to them.  Indeed, we typically perceive biases in others more readily than in ourselves, as this Stanford study finds.  This happens, in part, because we tend to focus more on our introspections than on our behavior, leading us to assume that we are not biased because, subjectively, our thoughts do not seem biased!  

Here is a telling anecdote:  I have worked as a performance coach for traders for a number of years.  People have sought me out for a variety of concerns, ranging from emotional interference with trading decisions to challenges in learning new markets.  How many--of the many hundreds of people I've interacted with in a coaching capacity--have expressly sought help for their cognitive and behavioral biases?


Traders are much more likely to attribute trading problems to emotional, psychological sources, external distractions, or evil market manipulations than they are to illusion, bias, and statistical artifact.  

What does that mean?

A staple of trading psychology wisdom is that one should trust their "processes" and remain grounded in them at all times.  But what if those processes involve subjective impressions from second-hand sources of unknown accuracy, poorly constructed statistical tests, or conclusions based upon limited, recent samples of experience?  The advice to stay process-driven presumes that traders operate in a bias-free manner--which is itself a beautiful example of the bias blind spot!

Suppose a trader's base case was that his/her own thinking could very well be biased.  In such an event, the trader's process would be replete with routines that test assumptions, validate sources, and explicitly entertain counterfactual scenarios and alternate explanations.  The trader seeking to minimize bias blind spots would be vigilant, questioning and even doubting all trade ideas.  How many of us do that in a structured manner and on a routine basis?  (Hat tip to the hyperrational colleague who inspired this question).

So who is more likely to be hired at the average trading firm:  the bold, confident trader who expresses great conviction in his ideas or the cautious, questioning trader who makes special efforts to avoid bias blind spots?  The answer to that question goes a long way toward explaining why average trading firms rarely sustain above average trading results.

Further Reading:  Hindsight Bias and Regret in Trading