Dear Financial Voice Reader,
Do you ever feel people only hear what they want to hear? Certainly, with Brexit it feels that way doesn’t it?
That’s a cognitive bias. It’s a blockage for making money too. When I wrote my first book, there was a very good reason I called it ‘The Mind of a Trader’. Every one of the 10 leading traders of the world I interviewed for the book told me that psychology was key to success and wealth.
One of my favourite interviewees was Bill Lipschutz, who was Global Head of Forex at Salomon Brothers so pretty much the largest forex trader in the world. His Chairman was Warren Buffett.
Your Mind is Your Profit
There are many biases that influence our reasoning. Popular literature recognizes 53 different types of cognitive biases however, four of them are particularly important and significantly influence risk calculations and strategic decision making.
These cognitive biases are:
Prior hypotheses and focusing on limited target- this happens when a decision maker brings hypothesis and personal beliefs into decision-making process without previously inspecting the relevant data. Consequently, the decision-maker tends to overlook the information and evidence that can prove the opposite of what he thinks.
This is a major problem for traders because instead of being detached and dispassionate when looking at data, they let their pre-existing trades and losses affect their future decisions.
Exposure to limited alternatives- in the situation when data is incomplete, decision makers tend to focus on limited numbers of alternatives because they usually fill in the missing data with intuition instead of trying to get additional information.
Traders here do trades they shouldn’t. Instead of waiting for high probability trades, instead they dive in impatiently.
Insensitivity to outcome probabilities- if a manager is influenced more by the value of possible outcomes then by the magnitude of probabilities, he/she will tend to make very risky and hazardous decisions that are not based on statistical calculations of probabilities.
Here the trader thinks how much money he will make, not how likely he is to make it. In trading, all we are trying to do is make small incremental gains, not huge windfalls.
In trading we need high probability trades.
Illusion of manageability- when decision-makers intuitively believe that success is more probable than what statistical models predicted they can become overly optimistic. Consequently, they tend to overlook risks and develop illusion of control in uncontrollable situations. In addition, in these situations, they irrationally think that they can and will solve every possible problem that arose as a result of their decisions .
When it comes to trading, it is vitally important to be aware of the biases which inflict everyone.