Trade with Logik Episode 3 discussed a few of the cognitive errors traders make and how you should approach them in the markets.
The podcast started off with a little mind teaser, which tests the mental states your brain can be in. System 1 is a mental state where you're intuitive, fast thinking and gives use humans that flight or fight response. Whereas, System 2 is our cool, cognitive and logical thinking brain, ones we use to solve complex problems.
The question it self was this...
“A bat and a ball cost £1.10 in total. The bat costs £1.00 more than the ball. How much does the ball cost?”
If you're like most people you probably said £0.10 or 10p. This is wrong. This is your system 1 quick intuitive thinking taking place. If the ball costs 10p then the bat would have to cost £1.10, if we add these together the full cost is £1.20. So... the true cost of the ball is 5p.
This is a great example which shows how things are not always as they seem, especially when you're monitoring charts and data in trading. Small mistakes can lead to catastrophic results. Learning to identify these situations will give you a great edge over your competition, other retail traders. The podcast then went onto discuss different biases and cognitive errors including hindsight bias, confirmation bias and ego depletion.
Hindsight bias is a tendency for people to overestimate their ability to have predicted an outcome that could not possibly have been predicted. What hindsight bias does is it makes us think we are better at predicting than we really are, causing us to be arrogant about our competencies and consequently take on too much risk.
In forex hindsight bias applies as you may look at charts countless numbers of times and create a vague prediction mentally in your head. This is your intuition and if you enter one of these intuitive positions and it works you believe that all your vague predictions have value and follow the same patterns or analysis as the other.
The trades that didn’t work are forgotten or you say things like “I should have closed my trade there” or “I shouldn’t have entered this”, afterwards you make try to support your bias decision with more bias laws such as confirmation bias.
This may happen when you enter a trade using certain analysis but then you add extra variables which you never do just to confirm and justify the position.
Therefore, keeping a journal in Forex trading is key to tackling this bias, logging your predictions, analysis and assets and comparing it to previous data allows you to analyse your personal data accurately. On top of this to prevent hindsight bias you could read historical diaries of others and other peoples experiences to prevent yourself from following the same bias path.
A confirmation bias is a type of cognitive bias that involves favoring information that confirms your previously existing beliefs or biases. For example, imagine that a person holds a belief that left-handed people are more creative than right-handed people.
In forex trading this can be extremely dangerous, let’s say you develop a trading strategy and you come up with a theory.
Any evidence there is that disputes your theory will be ignored and you will truly believe you are making logical decisions. In the end what’s really happening is you’re falling to this bias confirmation bias and you subconsciously decide to ignore evidence going against your theory.
One way to protect yourself from this bias is to be completely open to new market data and be critical of your theories. This way you will learn a lot more and be less likely to fall to the confirmation bias.
Another way you could prevent this from happening in trading is seeking mentorship from experienced traders who will help identify whether you are following your own trading rules or just ignoring market data to fit your own strategy.
Ego depletion happens when people use up their available willpower on one task. As a result, they are unable to exert the same level of self-control on subsequent, often unrelated tasks. Defined by Verywellmind.
In a sense this resource is limited in your brain so the more decisions you make throughout the day the less effective they become.
Here is a live example of one in the justice system:
"Danziger, Levav and Avnaim-Pesso (2011) analyzed legal rulings of Israeli parole boards concerning the effect of serial order in which cases are presented within ruling sessions. They found that the probability of a favorable decision drops from about 65% to almost 0% from the first ruling to the last ruling within each session and that the rate of favorable rulings returns to 65% in a session following a food break. The authors argue that these findings provide support for extraneous factors influencing judicial decisions and cautiously speculate that the effect might be driven by mental depletion. "
In a sense it suggested that without proper nutrition, sleep or health the individual's decision was heavily influenced. In Forex trading this is no different. When you're tired, hungry or had a long day. Your decisions are guaranteed to be worse, so you should avoid trading or be extra careful when making important decisions.
You don't want to be entering trades when you're hangry. This can lead to you missing out vital information. As your brain becomes more depleted, you then have less willpower which leads to more cognitive errors being made.
One method to prevent ego depletion is getting enough sleep, exercising regularly, eating before important meetings/decisions and staying hydrated.