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How Availability Bias is Secretly Sabotaging Your Trading

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time is money

time is money

Ever wonder why bubbles happen? Or why listening to gurus while you trade doesn’t seem to improve your performance? Availability bias has a lot to do with both these issues, and is a very common hindrance for traders.

In this, an article in a series on trading psychology, we’ll look at Availability Bias in trading. As the name implies, it’s a bias we hold internally which affects our actions, but of which we’re often unaware. If we look closely we can see the symptoms of the bias in certain trading tendencies, and once we have isolated the symptom we can dig deeper into the cause.

Do you have a plan for trading but seem unable to follow it? Or possibly you feel you have the knowledge, and have heard of so many people (who aren’t as smart as you) making money in the market that you don’t think you really need a plan? In either case, you’re likely falling prey to an availability bias, which will greatly (negatively) affect your trading.

Trading Psychology – Availability Bias in Trading

An availability bias is when you assign a probability to an outcome based on how many examples you can think of, or the most accessible data. An example was provided in What are the Odds Probabilities in Trading are Calculated Wrong?

Are there more six-letter words in the English language where the 5th letter is an n, or more six-letter words in the English language that end in ing?

Instantly the brain goes to work and thinks of many words ending with “ing.” So there must be more words that end within “ing”.

Not so fast.

The mind has taken a short-cut; just because it’s easier to think of words ending with “ing” doesn’t mean it’s more common than the “n” being the fifth letter. In fact, all 6 letter words ending in “ing” will have “n” as the fifth letter. There are more six letter words with “n” as the fifth letter.

This example is fairly easy to spot, and make sense of once explained. But other availability biases are much harder to see…especially in trading, as people get very passionate when money, reputation and credibility are on the line. Beliefs and biases which are easily dis-proven are clung to, defended using logical fallacies and passed along as stone-cold truth.

Availability Bias in Trading: Financial News

Does the stock market work on a cause-and-effect basis? For example, if there is positive news about the economy today, will stocks rise?
Convention wisdom says yes, positive news releases lead to positive stock performance, and negative news to poor performance. The media reinforces this everyday. Here a few headlines I saw over two days writing this article (originally written Nov, 2013):

-Stocks Close Lower as Yellen Testimony Looms – Yahoo! Finance

-U.S. stocks dropped as investors locked in gains amid Fed expectations – LinkedIn

-S&P 500 Climbs to Record as Macy’s Jumps Amid Fed Bets – Bloomberg

It definitely seems like there is a cause and effect relationship between stocks and the positivity or negativity of news events–or at least the writers believe so. But this too is an availability bias and it will lead you astray (read more at Do I Need to Watch the News to Be a Good Trader? – the answer is no).

An availability bias is when you come to a conclusion based on information you see most often, but may not necessarily be the most accurate information. Occasionally the information you see most often will be accurate, but usually there is an inherent bias.

News writers are trying to rationalize market movements based on events that occurred that day. All this proves is that a market movement occurred at roughly the same time as a news event, but it does not prove a cause-and-effect relationship. Also, the very reason spouted for a market movement today, will be used another day to rationalize a market movement in the other direction.

Speculation on the Fed decision was used to rationalize a stock market fall one day, and a rise in the stock market the next. Such headlines are useless and add nothing to the world of market knowledge or study, and in fact may lead readers into believing that uncertainty heading into a Fed decision could make stocks rise, or fall,with some certainty…and that’s just not the case.

All these writers and traders who base their market opinions on articles such as these are falling into an availability bias. They see cause and effect articles constantly, and therefore believe it is true. It may occasionally be right (randomness), but it is far from a good form of analysis. See: The Stock Market is Not Physics Part III.

When stocks are rallying like crazy, you’ll see loads of articles all trying to explain why stocks are flying higher. You’ll come to the “obvious” conclusion that buying stocks is the best thing to do. And maybe it is for a time, but even when stocks start to drop, you’ll still have all those reasons in your head about why owning stocks is so great. Since very few people are putting out warnings just after a market top, you draw conclusions based on the most available information….which is still “BUY BUY BUY!”

The danger is that you aren’t looking at what is actually going on in the market. Instead, you have chosen to rely simply on what you hear and read most often, which may not be an accurate representation of what is currently happening.

An even broader availability bias is that traders may begin to think they need the news to trade. After all, there is so much financial news that it needs to be discussed everyday all day on financial news channel, and articles are constantly pumped out on financial sites. “It must be important!” Some traders may use the news to trade successfully, but the premise that you need to trade with news simply because it is so readily available is false.

Availability Bias in Trading: Trading Success and Failure

Consider other things you hear and see often. For example, you may read trading forums and only see posts on how much money everyone has lost trading. You begin to believe that there is no money in trading anymore, and so you don’t bother trying.

On the other hand, you may see loads of articles and watch YouTube videos about novice traders becoming millionaires overnight. Since this information is so readily available to you you begin to believe it, possibly at great financial consequence. In both cases there is an availability bias. You’ve drawn conclusions based on how often you see or read something, and not whether it is factual or representative of actual probability.

Another availability bias which seems prevalent among some so-called-professionals and novices alike is “Trading is much harder today than it was before; the high-frequency traders will eat you alive.” This may not be a common belief, but since I do get emails about it, it’s worth addressing.

Trading has always been hard (we still study former crashes because they wiped so many people out), but there are easier times and tougher times. During a raging bull market anyone can buy and then sell a little while later to make money. So it is true that even the best traders will have better times and worse times, but does that make the belief statement above true? Not necessarily. It is bias by the amount of information pumped out about high-frequency trading, usually in a negative tone, people remembering the flash crash and commenting about it, and it makes a great excuse for those who aren’t making money to place blame.

Related to this topic is “survivorship bias.” With all the trading, analysis, news and signal websites/papers/books/articles/videos it makes it appear that there are vast amounts of successful traders. This may lead to believing it’s easy to trade; and much of the marketing related to these media sources encourages this belief. Yet simply because there are lots of trading sites/books/etc does not mean it is easy or that the vast majority of those who attempt trading end up succeeding. This is an availability bias based on survivorship–those who fail don’t usually put up websites or write books admitting it.

When you seek something out, you will find it. When searching for information, don’t only research what you already believe to be true, research evidence to disprove it.

Availability Bias In Trading: Trading Cliches

Consider these trading cliches you hear often: the trend is your friend, let your profits run, keep your losses small, only take trades with a good risk/reward ratio. 

If you read financial news or watch a financial news network you’ll hear at least 50 trading cliches a day. They sink into your head without you even realizing it. You hear them so often that they slip into your subconscious unquestioned, lying dormant until one it pops up to sabotage your trading plan.

I always take my profits within a fixed target range. That’s my strategy, it works for me and I stick to it. But occasionally the idea pops into my head “let the profit run.” If I listen to the voice, sometimes I may end up with a larger profit, other times a smaller profit. But that is not the point. “Let the profit run” is unquantifiable, therefore un-testable and only serves to deviate me from my plan. It doesn’t tell me where to get out, when to get out, how long I let it run (till it turns into loss???) or what criteria I should use to eventually exit. It is advice that is highly available, but creates a bias under which the parameters of your trade go from known to unknown.

Some of these cliches may have good advice hidden within them, but only when applied to a personal context. If I notice that my profits are getting smaller, I may choose to revise my system to try to capture larger profits. But such changes need to undergo a testing phase, where as simply deciding arbitrarily to let a profit run is untested, undisciplined and irresponsible.

Very often we fall prey to the information that is most readily available, but which isn’t in our best interest.

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