The last journal post spoke about 2 psychologists, Amos Tversky and Thomas Gilovich who in the 1980’s began sifting through shooting statistics from the Philadelphia 76ers – a US basketball team. The psychologists looked at every single shot taken by every single player, and recorded whether or not that shot had been preceded by a string of hits or misses. All told, they analysed thousands of shooting attempts in the hope of proving the ‘hot hand’ theory.
Tversky and Gilovich went onto prove that the ‘hot hand’ does not exist and that the streaks were a figment of our imagination, i.e. our intuitive feel for streaks was ill-founded. Each event was random in its outcome, and completely unrelated to all previous outcomes.
Even though data like this exists and proves beyond doubt that the existence of ‘streaks’ is purely random, people will still gravitate towards the belief that strings of events come in streaks and that these are somehow linked. This is known as confirmation bias.
The larger question, of course, is why confirmation bias exists. This is the sort of mental mistake that seems ripe for fixing by natural selection, since it always leads to erroneous beliefs and faulty causal theories. We’d be a hell of a lot smarter if we weren’t only drawn to evidence that confirms what we already believe.
As traders and investors we need to be aware of ‘streaks’ and to handle them with care. Whilst a string of winners has the same mathematical probability as a string of losers or even a string of win, loss, win, loss events, it is how we handle these streaks that has a huge impact on our results. If the system we are trading is having a run of winners, then this reflects the fact that it is in tune with market conditions and to maximize our returns we need to increase our exposure and position sizes to capture the available profits. We must also learn to handle our greed emotions so that we don’t start doubling position sizes and getting drawn into a false belief that the winning streak will never end, because it will. Similarly, when on a losing streak we must refrain from being drawn into the false belief that we will never have another winning trade and we are destined to lose all our money at the hands of the market and that the system is broken and will never work again.
Both of these emotional responses will result in monetary losses as well as psychological damage. Usually because the winning run will come to an end when we have just ‘bet the farm’ on the next winning trade only to see this trade wipe out all of the previous gains we have made, or the string of losing trades will come to an end just as we decide to stop trading because we falsely believe that the system isn’t working or that the markets are ‘rigged’.
Various psychological studies have shown that people have a very, very strong, robust confirmation bias. What this means is that when we have an idea, and we start to reason about that idea, we – mostly find arguments that support that idea. We come up with reasons why we are ‘right’ and then spend even more time justifying these decisions. And the problem with the confirmation bias is that it leads people to make very bad decisions and to arrive at crazy beliefs.
And to traders this is an extremely detrimental trait. It is why people spend hours deliberating over trades and then rationalising with themselves why they either should or shouldn’t enter the position despite all the criteria being met. It is also why people make irrational decisions to sell all their stocks out right at the bottom of a bear market or drastically increase their exposure right at the top of a bull market. It is why the subjectivity of technical and fundamental analysis in the wrong hands can very dangerous – indicators and ratios will be sought to confirm the notion that is already in the traders mind.
How can confirmation bias be counteracted? By using technical analysis and / or fundamental analysis indicators and ratios to disprove the notion. By taking the ‘disprove’ path you will put yourself in direct conflict with any confirmation bias that you may have. This can be called a “what if” mindset which stems from neutrality or a strong belief that “anything can happen.”
Or to use or design a researched rule-based approach.
By adopting a mechanical and rule based approach to trading and investing confirmation bias can be eliminated. If all the entry, exit and money management rules, which are determined to have an edge through research, are followed and flawlessly executed, then the trader really has nothing to fear or get greedy about, and there is nothing to rationalise or deliberate over. Trades are simply trades, neither good nor bad. They are simply entered and exited according to the rules of the system and all the emotional turmoil associated with confirmation bias and a host of other issues can be eliminated.