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Stop Confirmation Bias Before It Starts
01/03/2012 10:45 am EST
Confirmation bias can lead to false overconfidence and improper risk, says Darren Miller, who explains how to identify it and prevent subsequent losses to your trading account.
Dr. Darren Miller is my guest. Darren, I know you do a lot of advising and coaching of traders. Have you found any common theme or common mistakes that novice traders make?
Yeah, I think one of the biggest mistakes; it’s referred to as an heuristic, but it’s kind of a mental shortcut that they take, and it’s confirmation bias.
What do you mean by that?
Well, they’ll go out and they’ll find something that fits well with their belief system, and it may be the direction of a stock, or the importance of a certain technical indicator, or a combination of both of those.
Then, what they’ll do is tend to find research or others that have the same mindset, and then they’ll believe in greater detail that their initial thought is correct.
What that tends to do is lead to overconfidence in their strategy or in their position. That can lead to a big loss, especially if risk isn’t managed correctly, simply because they didn’t look at the other side. They didn’t look at the “What if.”
You know, when it comes to confirmation bias, there are really two parts to it. The heuristic side, or the shortcuts, the mental shortcuts, because we don’t like to, as humans, do tedious tasks. We don’t like to do extensive research and those types of things, so we’ll create these shortcuts.
A lot of times we don’t want to hear what we don’t want to hear, so we tune it out. How can we overcome that?
You have to make yourself aware of it, and often times that’s done post trade. You know, if you do an analysis of your trades, you’ll be able to pick up on that.
Sometimes people need someone else to point it out to them, and that’s where someone like myself or just a partner that you trade with, maybe you exchange e-mails with on a frequent basis, somebody that could help you right your ship and say, “You know, you didn’t look over here, and here’s the argument against your position,” and you can see where, in this instance, you were wrong.
Hindsight’s 20/20, obviously, but if you take the time to humble yourself and learn from that mistake, you’ll be able to make yourself cognitively aware of potential hazards in the future from confirmation bias.
Will online communities or chat rooms be one of the ways to also help with that?
You could. That also can be detrimental in and of itself because you can tend to gravitate towards those that agree with your viewpoint just as easy as you can shut out those that don’t agree with you. You know, “That guy doesn’t know what he’s talking about, or they don’t see what I see.”
That’s where that overconfidence comes into play. Usually it’s a hit in the wallet that will wake you up and say “OK, maybe I wasn’t right.”
That’s a lesson you learn and remember. What’s another common mistake?
I think another common mistake by new traders is trying to do everything. They may try to trade multiple markets, multiple time frames.
Are there times traders should be out of the market?
There are. You know, you often hear the saying that cash is a position, and for some, it is.
If there’s uncertainty in the market like we have now with the stuff that’s going on in European Union and the volatility at levels where we may see a 2% or 3% swing in the market in any given day, those are times that you can get chewed up if you have confirmation bias or some other bias that skews your vision of what’s going on in the market.
It ends up costing you not only in trading capital, but also in your mental capital, because nobody likes to lose and it’s defeating.