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Psychological Biases: Tricks Your Mind Plays on You and How to Overcome Them

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Traders often find themselves ensnared by common biases that hinder their potential for success. Recognising and conquering these biases is crucial to making sound decisions when navigating financial markets. Understanding your own mindset and being aware of these biases is the first step towards reaching your trading goals. In this article, we’ll explore several common biases that traders frequently fall victim to and discuss strategies for overcoming them.

Availability Bias

Availability bias, also known as recency bias, occurs when traders rely too heavily on readily available or recent information when making decisions. This bias can cause them to overlook vital historical data that could provide a more comprehensive perspective.

Recency bias causes people to overreact to rare events. An example of such are shark attacks. Movies and rumours make these attacks seem more frequent and significant than they are. In investing, this bias leads to exaggerated reactions to recent market events, affecting perceptions of market trends and outcomes, contributing to unwarranted fear in downturns and irrational exuberance in bubbles.

How to Overcome Availability Bias

To combat this bias, it is essential to have a well-defined investment strategy and stick to it, regardless of short-term market fluctuations. You can also consider using automated investment tools like robo-advisors, which remove emotional reactions from trading decisions.

Anchoring and Adjustment Bias

Anchoring and adjustment bias involves giving excessive weight to the initial piece of information encountered, or “the anchor,” when making subsequent judgments or estimates. Traders may anchor their decisions to a specific reference point and inadequately adjust based on new information.

In the realm of investing, anchoring bias manifests in various ways. Traders often fixate on the price at which they originally purchased a security, affecting their decisions on when to sell or buy more, regardless of the security’s actual value. Analysts can also become anchored to specific numbers, like Bitcoin’s price at around 27,000 to 30,000, leading them to predict values closer to that figure rather than considering the broader historical range and potential growth.

How to Overcome Anchoring Bias

To counteract this bias, consider consulting diverse models and evidence. Research has shown that those who consider multiple perspectives tend to make better forecasts. By avoiding reliance on a single model or idea, you can reduce the impact of anchoring.

Hindsight Bias

Hindsight bias leads traders to perceive past events as more predictable than they actually were, fostering overconfidence and distorting future decision-making.

One such example of this is Dogecoin, initially a meme-based joke cryptocurrency, which gained significant value in 2021 thanks to celebrity endorsements from Elon Musk and Mark Cuban. This surge left many regretting their previous dismissals, highlighting the unpredictable nature of the cryptocurrency market.

How to Overcome Hindsight Bias

To mitigate hindsight bias, be cautious when evaluating your ability to predict future market movements. Maintain a journal or diary to record your decision-making process and regularly review it. This practice will help you stay grounded and realistic in your assessments.

Confirmation Bias

Confirmation bias involves seeking, interpreting, or favouring information that confirms an investor’s existing beliefs, potentially leading to biased trading decisions.

An example of this is traders and investors who’ve previously profited from celebrity-endorsed altcoins may be tempted to centre their strategy around such assets, seeking further validation. However, it is essential to remember that past success does not ensure future gains, and no trading strategy is infallible, necessitating ways to address confirmation bias.

How to Overcome Confirmation Bias

Counter confirmation bias by actively seeking contrary advice and challenging your preexisting beliefs. Make a list of pros and cons for each investment and assess it with an open mind. Avoid asking questions that confirm your conclusions and instead inquire for more information to form an unbiased judgment.

Loss Aversion Bias

Loss aversion bias makes traders more sensitive to potential losses than gains, leading to risk-averse behaviour or holding onto losing positions longer than necessary.

For instance, when faced with a declining coin value, investors may resist selling to avoid realising losses and hold on to the coin, hoping to gain from its future growth. This is not always rational, as the coin may or may not recover from its slump, which depends on a myriad of underlying factors.

How to Overcome Loss Aversion Bias

Implement a strategic asset allocation strategy and periodic portfolio rebalancing as opposed to trying to time market sentiment. This approach provides stability and risk management, ensuring you don’t let losses hinder your progress.

In conclusion, traders must navigate both market intricacies and their own psychological biases to achieve success. By recognising and addressing mental biases as mentioned above, traders can make more informed decisions. Through disciplined strategies, self-reflection, and support networks, they can unlock their full potential and work towards their financial goals in the dynamic world of financial markets.

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