Trading in financial markets is an area where making smart choices and analyzing things carefully are super important. But, people’s minds often fall for biases that can mess up their decisions and make things not as good as they could be. One big problem is confirmation bias, especially for traders. This means that people tend to look for info that supports what they already think, while ignoring stuff that goes against it. This can really mess up their plans and how they invest their money.
In this article, we’re going to talk about confirmation bias in trading, looking at how it shows up, what it does, and ways to overcome it.
What is Confirmation Bias?
Confirmation bias is a cognitive bias that influences how people gather, interpret, and remember information. Traders afflicted by confirmation bias tend to seek out information that supports their existing beliefs or trading positions while disregarding evidence that contradicts them.
This bias often arises from the innate human desire for validation and the discomfort associated with cognitive dissonance, the mental stress caused by holding contradictory beliefs or ideas.
In other words, we search for information that confirms our beliefs.
Confirmation bias can show up in lots of ways. For example, someone might only look at news, articles, or social media posts that agree with what they already think, and they might ignore or say no to anything that says something different.
When people see info that doesn’t fit with what they think, they might not even realize it. Instead, they might change it in their minds so it fits with what they already thought.
There are a few reasons why confirmation bias happens. First, it makes people feel better by making them feel like they fit in with a certain group or idea.
It can also help people feel less bad when they have different ideas, which can feel weird.
And, it can be easier for people to understand info that fits with what they already think instead of really thinking about new stuff or stuff that says something different.
Confirmation bias can cause some problems. It can make people believe stuff that’s not true and share it with others, without really thinking about if it’s true or not.
It can also stop people from making good decisions because they don’t think about other ideas or info that might help them make a better choice.
Example:
When you look up “why milk is bad” online, you’re basically trying to find proof that agrees with what you already think—that milk isn’t good for you. But it’s important to know that this isn’t a fair or unbiased way to find information.
If you think milk is bad for you, it’s better to actively look for reasons why it might actually be good for you. This way, you can consider both sides and think about info that challenges what you first thought.
The big thing here is that if you only search for the bad things about milk, you’ll only find stuff that says it’s bad, without ever learning about any good stuff.
Imagine someone who doesn’t eat meat looking up online about why eating meat is bad for your health. That’s not really the best way to go about it.
The better thing to do is to actively search for info that disagrees with what you already think.
If you’re thinking about cutting milk from your diet, it’s a good idea to search for reasons why milk might be good for you instead of just focusing on the bad stuff. By looking at info that goes against what you first thought, you might end up changing your mind if there’s good evidence that your original idea was wrong.
How Confirmation Bias Affects Trading?
Selective Information Processing: Traders affected by confirmation bias may seek out and give more weight to information that supports their preconceived notions about trade while ignoring or downplaying information that contradicts their beliefs. This can lead to an incomplete or skewed assessment of the market conditions and potential risks.
Overconfidence: Confirmation bias can fuel overconfidence in traders. When they find information that supports their initial trading decisions, they may become overly confident in the correctness of their analysis, leading to increased risk-taking without considering alternative viewpoints or potential pitfalls.
Ignoring Contradictory Signals: Traders influenced by confirmation bias may dismiss or rationalize contradictory signals in the market. They may stick to their initial position even when market trends or indicators suggest otherwise, leading to missed opportunities or holding onto losing trades for too long.
Lack of Adaptability: Confirmation bias can make traders resistant to changing their views or adapting their strategies based on new information. They may become emotionally attached to their initial beliefs, making it difficult to objectively evaluate the evolving market conditions and adjust their positions accordingly.
Example:
When you take a look at a stock and quickly glance at its chart, you might get an idea of where it could be headed. But that can be risky because once you start thinking that way, confirmation bias kicks in and makes you look for reasons that agree with what you first thought.
The tricky part about trading is that for any stock, you can find lots of reasons why it might go up and just as many reasons why it could go down.
The best way to handle it isn’t to make up your mind and then look for proof. Instead, it’s better to have a thought and then actively look for proof that goes against it.
If you think a stock is going to go up, try to find reasons why it might not.
Confirmation bias doesn’t just make us like info that agrees with what we already think; it also makes us not care as much about new info, which we should really pay attention to.
When confirmation bias and the anchoring effect work together, they make our biases even stronger and stop us from really thinking about new info.
It’s important to give more attention to info that disagrees with what we think and not pay as much attention to info that agrees with us.
To make sure confirmation bias doesn’t mess up trading, traders need to know about it and look for lots of different opinions, other ways of thinking, and info that goes against what they first thought.
Doing thorough research, looking at different sources of info, and regularly thinking about your own biases can help traders make better decisions.
When you find new info that goes against what you first thought, it’s important to be okay with changing your mind instead of just looking for more reasons to think you were right in the first place.
The ability to adapt and adjust our beliefs based on new information is essential.
Overcoming Confirmation Bias in Trading
Diversify Information Sources: Actively seek out diverse perspectives and dissenting opinions to counteract the tendency to cherry-pick information that confirms existing biases. Engage with reputable news sources, market analyses, and peer-reviewed research to gain a comprehensive understanding of market dynamics.
Embrace Disconfirming Evidence: Cultivate a mindset that welcomes contradictory evidence and alternative viewpoints as valuable inputs for decision-making. Actively challenge your own assumptions and seek out evidence that challenges your existing beliefs, rather than dismissing dissenting opinions out of hand.
Implement Systematic Processes: Develop structured trading plan and checklists to guide decision-making objectively. Define clear entry and exit criteria based on predetermined rules and risk management principles, rather than relying solely on intuition or subjective judgment.
Maintain a Trading Journal: Keep a detailed record of your trades, including the rationale behind each decision and the outcome. Regularly review and analyze your trading journal to identify patterns of confirmation bias and areas for improvement. Encourage accountability and self-reflection to foster continuous learning and growth as a trader.
Conclusion
Confirmation bias poses a significant threat to the success and longevity of traders in financial markets. By understanding the underlying mechanisms of this cognitive bias and implementing proactive strategies to mitigate its influence, traders can enhance their decision-making processes and adapt more effectively to dynamic market conditions. Ultimately, overcoming confirmation bias requires discipline, humility, and a commitment to intellectual honesty in pursuit of trading excellence.