What are cognitive biases in trading?
A cognitive bias is a systematic error in judgment: not a random slip, but one that pushes most people the same way under the same conditions. In 1974, psychologists Amos Tversky and Daniel Kahneman described three mental shortcuts, or heuristics, people use to judge uncertain events: representativeness, availability and anchoring. They are usually efficient, the authors wrote, but lead to systematic and predictable errors (Science, 1974).
Trading is close to a laboratory for those errors: every decision is uncertain, feedback is fast and noisy, and money makes each outcome personal. A bias rarely announces itself; it arrives as a thought that sounds reasonable, which is why the map at the top pairs each one with the sentence it tends to produce. Confirmation bias, reading every candle as proof of the trade you hold, is covered in trading psychology with fear, greed, loss aversion and overconfidence.
What is the gambler’s fallacy in trading?
The gambler’s fallacy is the belief that after a run of one outcome, the opposite becomes more likely, as if chance kept score. Tversky and Kahneman’s example: after a long run of red at roulette, most people believe black is now due. In trading it sounds like “five losses in a row, the next one has to work”, usually with a bigger position.
Hypothetical: a method wins 45% of its trades, and its trades are close to independent: one result does not change the odds of the next. Before you start, five losses in a row have a probability of 0.55 to the power 5, about 5.0%. Once they have happened, the next trade still wins about 45%, not more. Over 100 trades, a run of five or more losses shows up about 92% of the time (computed exactly), so the streak proves nothing; losing streaks in trading has the math.
The mirror image is the hot-hand belief: after four wins in a row, “I can’t lose today”, so size goes up just when luck has pushed confidence highest. Counter-rule for both: size comes only from your fixed risk per trade and the stop, never from the last few results. If size changes, it changes by a rule written in advance, such as halving the risk after a 10% drawdown from the peak.
- Gambler’s fallacy
- The belief that after a run of one outcome, such as several losing trades, the opposite outcome is more likely, although the odds of each trade are unchanged when results are independent.
What is anchoring bias in trading?
Anchoring is the pull of a starting number on an estimate that should ignore it. In Tversky and Kahneman’s best-known demonstration, people estimated the percentage of African countries in the United Nations after a wheel of fortune gave them a starting number. The median estimate was 25 for the group that got 10, and 45 for the group that got 65: a number they could see was random still moved the answer.
Traders have two favourite anchors. One is the entry price: “I’ll sell when it gets back to what I paid.” The market does not know your entry. The other is a past high: a stock that traded at $80 last year looks cheap at $40, although the business and its buyers may have changed.
Hypothetical: you bought XYZ at $50.00, planned a stop at $47.50 but never placed it, and the stock broke support at $46.00 to trade at $44.00. Getting back to $50.00 needs a 13.6% gain (6 ÷ 44), with the broken $46.00 support as the first resistance. Counter-rule: ask the fresh-money question, “Would I buy XYZ here, today, with a stop where the chart says the idea is wrong?” If not, the entry price is no reason to hold; see when to sell a stock.
- Anchoring bias
- Relying too much on a first number, such as your entry price or a stock’s past high, when judging a value or a level that should not depend on it.
What is the sunk cost fallacy in trading?
A sunk cost is money, time or effort already spent that you cannot get back; the fallacy is letting it decide what you do next. In a 1985 field experiment by Hal Arkes and Catherine Blumer, a university theatre sold season tickets at full price or at one of two discounts, assigned at random. Over the next six months, those who had paid full price attended more plays.
In trading, the sunk cost is usually a loss on the screen. Hypothetical: XYZ is $1,200 below your entry. Selling makes the loss feel real, so you hold, or buy more to lower the average, and the position grows exactly when the evidence is worst; see averaging down. The same pull keeps traders on a system they paid for after their own numbers say it does not work.
Counter-rule: the $1,200 is gone whether you sell or hold. Decide only on what can happen from here: is the reason still true, and would you open this position today at this size? Write the stop before entry, while nothing is sunk yet.
- Sunk cost fallacy
- Continuing a losing trade, strategy or plan because of the money, time or effort already spent on it, instead of judging only what can happen from now on.
What is recency bias in trading?
Recency bias is giving the latest results far more weight than the whole record; Tversky and Kahneman tied it to availability, since recent events come to mind more easily. In markets, Robin Greenwood and Andrei Shleifer studied six surveys of investors’ expectations from 1963 to 2011 and found them highly positively correlated with past stock returns, and strongly negatively correlated with the returns standard models predicted (NBER working paper, 2013).
For a trader: three breakouts win, so breakouts “work now” and size creeps up; three losses, and a method with 200 logged trades is dropped for one from a video. Hypothetical: your journal shows +0.18R per trade over 120 trades, and the last 5 trades lost 5R between them. They are about 4% of the record, and a run like that is normal for almost any method.
Counter-rule: judge a method only on a large, fixed window, such as the last 100 trades, by its expectancy and error range, on a set review day rather than right after a painful trade.
What is hindsight bias, and why does it hurt traders?
Hindsight bias is the “I knew it all along” effect. In a 1975 study, Baruch Fischhoff gave people accounts of historical events, some with the outcome and some without. Those told an outcome judged it more likely, and were largely unaware of it: they overestimated what they would have known without it (Journal of Experimental Psychology, 1975).
After a big move, every chart looks obvious. That makes you blame yourself for “missing” a move that was uncertain before it happened, and trust a forecasting skill you never tested; both push you toward bigger bets on the next “obvious” setup.
Counter-rule: write the forecast before the outcome. Log the setup, stop, target and a rough probability in your trading journal before entry, and review each trade against what you wrote, not what you remember thinking.
- Hindsight bias
- The tendency, once an outcome is known, to believe it was more predictable than it was, and to overestimate what you would have known beforehand.
What is the illusion of control in trading?
The illusion of control is the sense that you can influence outcomes that depend mostly on chance. A 2003 study by Mark Fenton-O’Creevy, Nigel Nicholson, Emma Soane and Paul Willman measured it with a computer task given to 107 traders in four organizations: those with more illusion of control were rated lower by their managers and earned less in total pay.
For a retail trader it is watching every tick, adding trades because sitting still feels lazy, or moving a stop because you “feel” the turn coming. None of it changes the odds; all of it adds costs and mistakes.
Counter-rule: put your effort into what you control, which is the setup, the size, the stop, the number of trades and when you stop for the day, and set price alerts at your levels instead of watching. It also helps with trading anxiety and burnout.
A bias check to run before every trade
You cannot feel a bias while it works; you can catch it with questions written in advance. Add these to your trading plan checklist:
- Is my size what my rule says, whatever the last five trades did? (gambler’s fallacy, hot hand)
- Would I open this trade with no position and no history in this stock? (anchoring, sunk cost)
- Am I judging my method on the last 100 trades, or on the last three? (recency bias)
- Did I write the stop, the target and my reason before entry? (hindsight bias)
- Is this trade in my plan, or am I trading because I am watching? (illusion of control)