Top 50 List of Cognitive
Biases in Trading
Written by Adrian Holliday for Capital.com
Behavioural biases play a big part in your trading. They affect how you enter and exit the market. Your trading performance will improve if you know what’s working against you so you can make more objective, rational decisions. Discover the ultimate list of cognitive biases in trading.
#1: Martingale Bias
Martingale theory relies on consistently doubling up on a bet when you lose – lose, double your bet; lose again, double your bet again. This is a super-high-risk approach. Think multiple flashing dashboard warning lights.
The theory has its roots with French gamblers in the 18th century. The premise here is that those who lose regularly can’t lose all the time – statistically it’s impossible. But no one has an infinite cash supply.
Your (considerable) foes are unpredictability and economic, regulatory and political risk. Risk a lot to win a little? Yes. Think Get Poor Quickly.
#2: Hot Hand Bias
This is the irrational view that consecutive winning or losing means your hand is ‘hot’ or ‘cold’. The thinking goes that because person X may have won several times in a row, they’ll win next time also.
This is a built-in dangerous cognitive bias and a misguided view of chance under most conditions (a so-called ‘winning streak' often precipitates disaster).
Generally, previous successful outcomes do not influence longer term performance. In investment terms a ‘hot hand’ is a very long distance from solid, fundamental valuations.
#3: Gambler Fallacy Bias
Also known as the Monte Carlo fallacy, this is the idea that odds will even out and can be exploited under normal conditions.
Think of a roulette ball. It may land consecutively several times on red. The gambler fallacy is based on the premise that – very soon – the roulette ball must land on black. Per se, a roulette has no memory.
And the spin of the ball has no connection with previous spins of a roulette wheel. Ever. History, then, goes in the bin.
#4: Clustering Bias
This cognitive bias is susceptible to seeing patterns where none may exist. Clustering bias relies on an expectation of probability or some illusion of control.
A clustering bias means it’s probable that to extend a winning streak you should keep to an existing strategy. It rejects, to a greater or lesser extent, variability or chance. It has some overlap with the gambler fallacy.
#5: Ambiguity Effect Bias
The ambiguity effect is when you prefer the known probability of something familiar over a second choice where the risk is less well known.
As far as investing goes, you might have a choice of solid government bonds where the interest rates are guaranteed in advance. Or, the chance to invest in shares where there’s less certainty – but a reasonable probability of a better return over time.
You possess known information about the bonds versus an absence of information about the stocks. Sometimes the ambiguous choice would produce a better return.
Do some fundamental analysis about your less-known option rather than just choosing the known option.
#6: Herd Instinct Bias
The psychological herding instinct is particularly apparent with trading and investing.
Media headlines in the business pages might talk of promising new markets or technology. Or the successful history of a fund manager (and the corresponding poor behaviour of another).
Often, this market ‘noise’ drives up prices to unsustainable levels. Billionaire investor Warren Buffett did not pile into IT stocks in the late 1990s’ disastrous tech bubble.
In other words, don’t get drawn in. Especially when fundamental values appear to be ignored.
Most people get interested in stocks, when everyone else is. — Buffett once said. — The time to get interested is when no one else is.
#7: Disposition Bias
Boiled down, this is the fear of selling too early or too late. The disposition bias applies to multiple commodities, from shares to classic cars to property. At its core is the anxiety of possible losses.
For example, you buy into a stock that has appreciated sharply in value. The future fundamentals remain good – earnings, cashflow and debt levels. Yet you sell because, despite all evidence to the contrary, you fear the uptick can’t last.
It goes the other way: you refuse to sell a poorly performing stock because you prefer to wait for it to come back, even if the fundamentals don’t support a return to health.
This cognitive bias often includes large doses of pride resulting in – key here – illogical behaviour.
#8: Confirmation Bias
A confirmation bias is when you ignore or filter out anything that doesn’t square with your beliefs or prejudices. When you’re trading, this can be dangerous.
If you’re on the losing end of a trade, any news-related information supporting your existing position can be grabbed and clung to. Despite the facts. Or a larger truth.
A confirmation trading bias, then, means we ignore inconvenient information. One strategy to combat such bias is to actively seek out information that contradicts our own views – and listen hard to the reasoning and facts behind them.
#9: Recency Trading Bias
This is when you only focus on recent trading decisions, or the most recent outcomes, be they successful or not.
It means you’re abandoning logic and a solid trading strategy because you’re running on emotion. This myopia increases the likelihood of a future loss.
You can counter recency bias by approaching every trade as a fresh one and reminding yourself of your broader goals. That takes discipline.
Regularly recording your trades and results will remind you of the long-term foundations on which your trading system is built, and the effectiveness of your decision-making. In other words, keep to the plan.
#10: Hindsight Bias
You could call this cognitive bias a tendency to over-simplify. Hindsight bias, through the fog of memory, often means certain events loom larger in the mind than they did at the time.
That means it’s easy to ascribe cause-and-effect reasoning to it: that the event was completely predictable. The problem with ‘hindsight’ in trading is that it can lead to poor future reasoning. Or over-confidence.
However, the past never repeats itself. It is always difficult to predict the future. Hindsight bias has close links with confirmation bias.
#11: Anchoring Bias
An anchoring bias is when you may over-emphasise how much you pay for a trade. For example, you buy 10 shares for £10. The value of the shares promptly drops 20%.
But instead of absorbing the loss, you hang on for a hoped-for recovery because you haven’t got 100% of your money back, even though your trade may be close to your original ‘buy’ point.
This is a dangerous bias because your ‘anchor’ is utterly irrelevant to the rest of the market. Closely linked to the disposition bias.
#12: Attentional Bias
Here, we’re talking about paying attention. But not paying attention to all possibilities and options. So you may be focused on giving time to certain shares, asset classes or currencies but not others that may also be relevant – for any number of reasons.
Call it selective attention. It’s particularly applicable where different share classes or events look or feel familiar. Consequently, you make decisions at the expense of alternatives that might perform better.
This cognitive bias is often related closely to how you might feel emotionally at the time.
#13: Neglecting Probability Bias
This is another reasoning bias. Statistically, we know that travelling by train is safer than by car (in the UK, the Department of Transport can supply the fatality statistics to prove it).
But neglecting probability may ignore lower level, more mundane risk, such as a bad diet that undermines your health long term.
In trading, probability neglect might be a failure to assess a stock in a qualitative way – especially when there’s a significant degree of uncertainty – be it with careful modelling or other risk assessment possibilities.
Bottom line: neglecting probability bias skews your judgement.
#14: In-Group Bias
In-group bias often relies on a status quo or group-think that distorts reality beyond your peer group. This bias has any number of examples and can often mix up politics and money.
Think of the UK Brexit vote in 2016, which showed the media was out-of-touch with many voters (the referendum also led to a massive depreciation of sterling, weakening some people’s investments).
The point being that an in-group bias discriminates against other options. It can weaken your judgement about a wider reality, whether you’re trading or not.
#15: Post-Purchase Rationalisation Bias
This is about justifying a trade position or a consumer product you’ve saved for after you’ve bought it. Even if it turns out bad.
This cognitive bias means we may strongly remember aspects of the decision-making process (though these memories may be distorted) and our judgement about rejection possibilities at that time.
The memory of these past ‘rationalisations’ may play a part in our future decision-making – which may be ill advised. In other words, always be honest about why you bought a trade and learn from it.
Post-Purchase Rationalisation can also be called Choice-Supportive Bias.
Oh, I’ll keep it long term, then, and see how it works out…
#16: Survivorship Bias
Focusing only on those that have passed some form of test means you risk your investment choices repeating failures you had ignored. It distorts your wider field of choice. How might you discriminate effectively if poorly performing companies – which may have gone to the wall, for example – aren’t on your watch lists?
This bias can skew a broader investment valuation, particularly for mutual funds such as unit trusts that may own other companies from similar asset classes. Survivorship bias has strong links to selection bias.
#17: Selection Bias
This bias is dangerous because, at its worst, it can show some choices in a deceptively attractive light. That may mean deteriorating trading judgements if there’s a reliance, for example, on out-of-date or incomplete information.
The same goes for trading systems that may claim an advantage over others. For the vast majority of traders, there are few methods of trading or cognitive biases that outperform or supply an ‘edge’.
So, only trade on systems that are well known and robust and that absorb as many legitimate information channels as possible.
#18: Automation Bias
Typically, automation bias is when too much of a decision-making process is deferred to automated systems, often highly accurate. Over time these systems may be seen as infallible. Therein lies danger.
A particular problem with automation bias is that it can change how you approach a decision – following well-trodden paths of least resistance – and leading to fresh errors.
This bias has crept into many industries, particularly transport and healthcare. It’s increasingly widespread in trading and investing, lowering costs and improving liquidity. Automation advantages are many but the in-built bias, you’re warned, remains.
#19: Availability Cascade Bias
Availability cascade bias can be significant because it’s often personally felt or seen. It has strong roots to story-telling - you were there. This adds power and intensity to your trading decisions. The problem with this cognitive bias is that it can be difficult to push beyond it.
To check facts and properly validate. To get a longer view. Availability cascade bias can be offset by remembering that markets are cyclical and that buying on fundamentals – fair value, good management – keeps your decisions straight and clean.
#20: Blind Spot Bias
Essentially, your trading judgement tells you that other people’s judgement is biased – though you’re unable to recognise your own blind spots.
This lack of awareness can make it more difficult for you to take independent advice, or discriminate generally across your trading portfolio.
Even when you have a grip on your own biases, it doesn’t mean you are able to overcome them any better or worse than those who have more self-awareness.
#21: Home Trading Bias
Despite strong evidence that trading overseas can be profitable, you stick to home turf. Logically, most traders and investors know that investing in a wide range of global investments, currencies and asset classes provides strong diversification risk.
It’s also the chance to invest in low valued second-world economies as they develop long-term. Or to have extra protection against currency gusts and squalls, as well as a hedge against political risk.
But the urge to keep to the familiar is strong. Even for the very experienced.
#22: Endowment Effect Bias
This cognitive bias is when we place too much value on a trade or object we already own.
An endowment bias can mean you may be willing to pay more for shares, for example, if you already own shares from the same company. In contrast to buying shares from a company you haven’t bought into.
This bias has a strong relationship with ownership – you pay more to invest what you already own, compared with what you don’t own. Longer term this can reduce the potential value of your investments, even increasing risk levels.
#23: Attribute Substitution Bias
Think plausible short cut. This is when an inaccurate substitution or judgement is made. A trader might buy an asset without giving enough thought to its underlying volatility.
Or they study a complex asset class and make a quick, ill-judged decision about the long-term prospects because these prospects sound reasonable enough. Whatever the judgement, it’s likely to be wrong. Or inappropriate.
This lack of self-awareness may make little difference, even when pointed out (adding to the peril levels). It’s natural for the human brain to throw out rapid, apparently sensible judgements that aren’t thought through. (How else do some people get through their day?)
#24: Framing Bias
We use framing biases to reach many decisions, not all of them good. These framing devices may be stock charts, information from the internet, including opinion from peers, or even prices we see in the high street. These valuations can be manipulative or misleading.
With fewer framing reference, you are more likely to make judgements on basic market or trading fundamentals: P/E ratios, management reputation, liquidity.
Your perception stands a better chance of objectively valuing a trade or stock if some framing references are removed.
#25: Backfire Effect Bias
Another barrier to objective thinking is the backfire effect bias. This is when a more objective or accurate view actually accelerates prejudice or cognitive bias in the other person.
That’s because another view may tip them into defensiveness, or threatens their underlying beliefs. In trading, this may lead to even more irresponsible actions or decisions.
Ways to address it include keeping emotion out of an argument and showing basic respect for the other person or argument, even if you don’t feel it.
#26: Contrast Effect Bias
This is a framing bias that can affect how we make decisions based on previous experience. For example, we might be looking at buying some shares in ‘XYZ’ stock following positive regulatory news for XYZ.
However, we may then see a cheaper trading opportunity for a company also expecting positive regulatory news, which hasn’t materialised.
The temptation might be to pile into the second company, trading at discount, though the regulatory value isn’t confirmed because it still looks great value in comparison with the other stock.
#27: Bandwagon Effect Bias
This bias is responsible for many bad investment decisions, not to mention market bubbles. It’s when market valuations soar on herd-like demand at the expense of basic, sensible valuation metrics.
There’s no one route to avoid it other than to ensure your trading and investment decisions remain based on solid fundamentals. In the financial world, there is never safety in numbers. But there is some insulation in independent and – you hope – objective research.
#28: Loss Aversion Bias
Often the best response to a losing trade is to cut your losses and sell (often integral to many people’s basic risk management trading plans through stops and other devices).
A loss aversion bias might prevent you from doing this because the loss is a shock (and can be exacerbated by leverage). This cognitive bias is rooted in the hope of a turnaround. It can be a long wait, especially if you think the upside potential remains strong.
This bias can, potentially, be dangerous as it limits the chance to move on to the next opportunity. At its heart, loss aversion does not accept that trading losses are inevitable, normal and part of everyday life.
#29: Impact Bias
Impact bias is what happens if you overestimate the significance of what you think may happen in the future. This bias looms large in your decision-making and may influence how you respond to trades or risk generally.
Let’s say you feel a long-term shift – perhaps in favour of oil and gas assets – looks likely. You respond by making substantial trading adjustments instead of accepting that periodic changes are part of the ebb and flow of the market.
In reality, your expectation of what may happen in the future is less hard-hitting or intense than what actually happens.
#30: Status Quo Trading Bias
Status quo bias is a reluctance to change your mind about an established gain or loss reference point – even when presented with the facts of a strong opposing argument.
Status quo bias can be dangerous as it does not allow you to respond flexibly to change. It has close links to loss aversion bias because it can be a reluctance to move on. It has close emotional links to rigidity.
#31: Déformation Professionnelle Bias
In short, are you wearing blinkers? This cognitive bias is a tendency to examine your exterior environment via your professional capacity at the expense of a more balanced view.
That means you’re more vulnerable to making poorer decisions when trading because it’s hard to take on other people’s opinions. You only see through your own lens.
Originally attributed to Russian-American sociologist Pitirim Sorokin.
#32: Normalcy Bias
In trading, it can mean a lack of ability to take on new ideas or to respond promptly to events or signals with which you have little experience.
Normalcy bias means the inclination only to plan ahead for what you think may happen as opposed to what could happen. In terms of risk management it’s about a need for preparation.
This is a bias that the insurance industry is skilfully adept at deploying and packaging.
#33: Reversion to the Mean Bias
This is a bias or belief that returns are likely to be more reliable over the long-term than the short-term. Or that periods of poor returns are followed by stronger returns.
Deploying a variety of metrics – earnings ratios and dividends, for example – it’s possible to have a clearer picture of long-term trading ranges of some assets. These are especially useful when trying to understand valuation bubbles.
Be aware that some assets do not revert to the mean. In other words, they behave beyond regular patterns.
#34: Omission Cognitive Bias
This is when you may think that not acting or responding to an event is better than responding.
For example, you might be offered a chance to trade in a stock that has negative environmental consequences. You don’t trade, even though you are giving up a possible chance of a profit.
Faced with a difficult situation, the impulse is to steer clear of a decisive action, one way or other. Omission bias can be connected to moral choices.
#35: Focusing Effect Bias
This is a cognitive bias that warns of simplistic cause-and-effect outcomes or a reliance on your own, possibly strongly held, experiences. In finance, the focusing effect bias often plays into expectations of future performance based on past events.
This is sensible, up to a point. The problem with any focusing bias is that a very wide range of factors generally determines most outcomes. Tackling focusing bias is about accepting that decision-making is much more nuanced than may be given credit for.
My judgement on that trade was successful because I knew the asset was undervalued by everyone else.
#36: Self-Attribution Bias
You might well abbreviate this to ‘bigging’ yourself up.
The problem with this bias (or ego) is that it is often poor at taking responsibility when things go wrong. This bias is also wide of the mark when things go right. That’s because many factors that influence an outcome are typically at play.
This bias is additionally worrying in trading because it can lead to over-confidenceand rashness.
#37: Current Moment Bias
Current moment bias has its roots in hunger and gratification. In trading terms, this means the temptation to take profits too soon because you want to enjoy the spoils. Or to chase the next best thing.
It also has a maturity element: why worry about the future when you could enjoy now? This is a human cognitive bias that government and the pension industry in particular continue to wrestle with.
#38: Frequency Illusion Bias
Last week, perhaps, you stumbled across a new company that sounded a good trading opportunity. Then, over the weekend, the same name popped up on a radio programme. There was more contact when it popped up on a YouTube advert two days later.
Every repeat supplied heightened subliminal reassurance; unconsciously you were watching for that name, even when you knew little of value about that company.
Sometimes this bias is falsely attributed to intuition (which itself can be highly flawed). Frequency Illusion bias is also known as the Baader-Meinhof bias.
#39: Affect Heuristic Bias
This bias means your trading decision-making can be profoundly affected by your emotional state. If you’re in a positive frame of mind, you’re more likely to respond positively and quickly to, say, a certain stock market trade.
The converse – feelings of negativity – also occurs. It’s a reasoning cognitive bias that supports quick decision-making.
In the financial world, it’s particularly connected to situations where familiarity might attract a more positive response to a stock or brand name compared with a less familiar name potentially carrying higher risk (or not).
#40: Negativity Trading Bias
A negativity bias can potentially suck you away from action and decision-making. This bias is similar to a glass half empty as opposed to a glass half full.
As it sounds, this bias tends to slide towards a negative outcome rather than a positive. Negativity basis is good in the sense that it can make you cautious. It’s not so healthy when it blunts your own sense of potential or skews your judgement.
#41: Decoy Effect Bias
This is typically a coercive cognitive bias used in marketing and selling. It may be a situation where consumers are given a choice of products but where the selection process is disrupted by an extra choice – a third or fourth, possibly mis-priced.
In financial services and trading, it may mean an overload of investment options, resulting in rushed, poor-quality decisions. Especially when there may be time or news and/or price pressure applied.
#42: Regret Theory Bias
Practically, this means you risk feeling emotional about a possible trading loss for which you might be responsible.
In the shorter term, it might mean you hold onto a losing stock longer than you should. Longer term, this bias can prejudice how you might feel about other investing decisions.
In financial terms, this can lead to rising levels of risk-averse behaviour – avoiding stocks and shares and sticking to government-backed gilts.
#43: Hard-Easy Bias
Very simply, this involves over-confidence on hard-to-crack issues and under-confidence on easier ones. To overcome this bias, a more systematic decision-making process is demanded rather than succumbing to natural biases already present.
This cognitive bias is particularly important for entrepreneurs or anyone involved in regular enterprise risk management situations across a wide range of industries.
#44: Conservatism Cognitive Bias
If you cling hard to your beliefs, you may have, at one level, Conservatism Bias. In the financial world, this can mean you may be slow to respond to new data or events, compromising your judgement.
Behavioural finance studies suggest this bias is part of ‘belief perseverance’. It has consequences for complex information situations where there’s an expectation or onus on you to absorb new information and to make adjustments.
This bias has a close relationship with Affect Heuristic Bias (and other ‘belief’ biases).
#45: Mental Accounting Bias
This is a reasoning ability to manage your spending behaviour, usually into different buckets.
For example, if you have a healthy mental accounting bias, you may regularly put aside money for the long term while freeing up another ‘pot’ of cash for shopping, trading or paying back a credit card.
This bias is closely related to risk attitude. If the value of your long-term pension dips £500 in value in a day, it’s not the same thing as losing £500 in a bad trade.
It goes the other way too. A £500 winning trade could be invested safely long term, or risked again with another trade. Either way, money is still money.
This cognitive bias has close links with Hyperbolic Discounting Bias.
#46: Hyperbolic Discounting Bias
Hyperbolic discounting bias means we reach for the smaller reward now rather than the bigger prize further down the line. It’s a form of bias that goes against common sense and logic.
Human brains have a natural desire for gratification rather than the bigger long-term reward. In the trading and financial world, hyperbolic discounting is everywhere.
Witness day-trading and shorting compared with the saving-for-the-future trudge, steadily absorbing dividends and monthly direct debits – decades of saving.
#47: Duration Neglect Bias
This cognitive bias claims painful experiences resonate more powerfully depending on the intensity of an experience, as opposed to the length it actually lasts.
In trading, for example, this bias may in fact be disproportionate to an actual loss. The phrase ‘peak-end rule’ is sometimes associated with Duration Neglect – how the experience was judged at its most intense moment, rather than the overall effect or loss.
#48: Law of Small Numbers Bias
This behavioural bias is linked to ‘sample size’. Or the tendency in any professional discipline, including trading, to draw conclusions from small amounts of data randomly collected.
Supporters of this bias argue that a small sample size avoids random patterns or clusters. However, the converse can be (very) strongly argued also. The fundamental problem with this bias is that a too-small sample size undermines the integrity of the result.
This bias is often a lazy shortcut used for seeking coherence where none may exist.
#49: Theory-Induced Blindness Bias
Often you make a wrong judgement with a trade. But admitting it is not always easy – and that can sometimes bring on theory-induced blindness bias.
That means you may resort to no end of excuses to explain it away: Something happened I couldn’t control…I didn’t realise X was a bigger issue than it was... etc.
This cognitive bias travels well beyond finance, spilling into politics, marketing and other disciplines.
#50: Restraint Bias
If you think you can rein yourself in and avoid less-wise trades but you still fail, this is restraint bias in action. Restraint bias shares some genes with addictive behaviour. It has its roots in focus and self-control – or rather a lack of focus and self-control.
The problem with restraint bias is that, in isolation, many underestimate how powerful it actually is. In practice, it’s highly potent and carries high risk levels.