In the world of trading, making rational decisions is a daily bread. However, this "bread" can be spoiled and made indigestible by unconscious and automatic mental mechanisms that can compromise analyses and influence operational choices. These are the so-called cognitive biases.
In this article, we will analyze how these cognitive biases interfere with the trader's activity and how they can be effectively managed.
Why cognitive biases in trading are a risk
Cognitive biases can be considered systematic errors of thought, caused by "mental shortcuts" adopted to make quick decisions.
Although useful in some everyday life situations, these patterns become dangerous in the context of trading, where decisions must be based on objective data, analyses, and well-defined strategies.
The influence of cognitive biases can lead to overestimating some information, ignoring others, acting impulsively, or remaining anchored to no longer valid positions. The result is a distortion of reality that undermines the quality of decisions and, consequently, the economic results of trading activity.
Understanding cognitive biases means recognizing the mental traps that are automatically activated. Only by becoming aware of them is it possible to develop a critical approach, reduce emotional influence, and increase operational clarity. This process is particularly important for everyone, but especially for those who operate independently, without a support team that can "watch their back" and somehow defend them from themselves.
The main cognitive biases and how to overcome them
The first step to neutralizing cognitive biases is to recognize them as such. Only when one is aware of their existence and the ways in which they manifest can their impact be reduced. Below, we illustrate some of the most common cognitive biases in trading, specifying the operational consequences and presenting the best strategies to avoid them.
Confirmation bias
Confirmation bias consists of the tendency to seek, interpret, and remember information in a way that confirms one's pre-existing beliefs. In trading, this translates into selectively analyzing data, ignoring elements that contradict an already taken position.
This bias can lead to holding losing trades for too long, refusing contrary signals from the market. To counteract it, one can adopt a structured approach to analysis, consult different sources, and confront opposing opinions, systematically asking oneself: what if I were wrong? It may seem uncomfortable, but doubting oneself represents, in these cases, a winning weapon.
Loss aversion
Loss aversion is the tendency to fear losses more than one appreciates a gain of equal magnitude. This mechanism can lead to prematurely closing profitable trades to secure gains, while being willing to leave losing positions open in the hope that the market will turn favorable.
This behavior compromises the risk/return ratio and reduces the efficiency of trading strategies. To overcome it, it is necessary to set precise risk management rules, use consistent stop losses and take profits, and respect them in a disciplined manner, without modifying them based on emotions.
Anchoring effect
The anchoring effect occurs when excessive weight is given to an initial piece of information, which influences subsequent evaluations. In trading, it can happen, for example, to consider a specific entry price as a reference, even when the market context has radically changed.
This bias can lead to irrational decisions, such as not wanting to exit a negative position just because "it has almost returned to the purchase price." The solution is to learn to re-evaluate each position in light of new information, without being influenced by obsolete or irrelevant information.
Hindsight bias
Hindsight bias is the tendency to believe, after an event has occurred, that it was predictable. This can lead to judging oneself too harshly for past mistakes or overestimating one's future forecasting ability.
In trading, this bias generates an illusion of control and a false sense of security, which can lead to taking overly risky decisions. To avoid it, it is useful to maintain a trading journal, with the reasons for the choices made, to objectively compare ex-ante decisions with ex-post results.
Overconfidence bias
The overconfidence bias leads to overestimating one's skills, intuitions, or forecasting abilities. It is particularly dangerous in trading because it induces taking on excessive risks, increasing financial leverage, or opening too many simultaneous operations.
Overconfidence can stem from a period of positive results, which are entirely attributed to one's skill and not, in part, to chance or favorable market conditions. To counter this bias, it is essential to adopt a written trading plan with precise rules to follow and analyze results on a statistical basis rather than focusing on individual trades.
Herd effect
The herd effect is the tendency to adopt behaviors similar to those of the majority, either for conformity or fear of being wrong. In financial markets, this translates into decisions made based on general sentiment or mass behavior rather than personal assessments. A classic example of the herd effect is panic selling.
The most effective way to avoid this bias is to have a well-defined strategy and stick to it, regardless of consensus or social pressure. It's about isolating oneself from the outside world, but selectively, i.e., excluding the trading community from one's reasoning.
