Let’s assume that you have a thoroughly tested, proven trading system, and determined it to be something you can trade. Unfortunately, it does not automatically means you can start profiting from the system. There are psychological biases - biases that tend to cause people to override their systems.
People want maximum performance, so there is always a temptation to override your trading system. The few times you do something to override your system and improve your performance that work really stands out in your mind. However, you tend to forget the times that don’t work and the day-in, day-out slippage (i.e. the cost of trading) that affects your bottom line.
If you don’t have a trading system at all, then numerous biases affect your trading. However, several key biases come into play even when you have the best of systems. Let’s take a look at these biases that tend to cause people to override or not follow their systems.
Gambler’s fallacy bias
The gambler’s fallacy is the belief that when a trend established in a random sequence (or in the market, for that matter), the trend will change at any time. Thus, after four consecutive up days in the market we expect a down day. Even people who are well-respected researchers of the market suffer from this bias.
People assume that the probability goes up for a win after a losing streak or up for a loss after a winning streak.
When you understand what’s involved in winning, as do professional gamblers, you’ll tend to bet more during a winning streak and less during a losing streak. However, the average person tends to do exactly the opposite: to bet more after a series of losses and less after a series of wins.
Conservative with Profits and Risky with Losses Bias
Perhaps the number one rule of trading is to cut your losses short and let your profits run. Those who can follow this simple rule tend to make large fortunes in the market. However, most people have a bias that keeps them from following either part of this rule.
People, once they have a profit in hand, are so afraid of letting it get away that they tend to take the sure profit at any sign of a turnaround of the market. Even if their system gives no exit signal, it is tempting to avoid letting a profit get away that many investors and traders continue to lament over the large profits they miss as they take sure small profits.
People want to take profits quickly and give their losses some room. This gives them the illusion of being right, but what they are really doing is “cutting their profits short and letting their losses run.”
These two common biases are well stated in the old saying: “Seize opportunities, but hold your ground in adversity.” The good trader had better use the adage: “Watch profit-taking opportunities carefully, but run like a deer at the first sign of adversity.”
Bias that “My Current Trade or Investment Must Be a Winner”
What makes all these problems come to the forefront is the overwhelming desire of human beings to make current positions (those you have right now) work out. What happens? First, when you have a losing position, you’ll do anything to nurse it along, hoping it to turnaround. As a result, losing trades tend to become even bigger. Second, profits are taken prematurely in order to make sure they remain profits.
Why? People have an overwhelming desire to be right. Over and over again, I hear traders and investors telling how important it is for them to be right when they make a market prediction or, even worst, when they invest their money in the market.
Once a person makes a prediction, the ego becomes involved in it, making it difficult to accept anything that happens in the process of trading that seems to differ from your prediction.
This bias may be at the root of all other biases. Yet being right has nothing to do with making money.
