• James He

Five cognitive biases you need to know when day-trading

While most of us have been stuck at home, the stock market has been wild. First, the unexpected COVID-bull and the rocket-rise of Tesla, then comes r/WallStreetBets. Lured by this excitement, many have started day-trading.

But when the market roars at our ears, it is hard to stay rational. After all, we are humans: evolution didn’t give us rational evaluations, but cognitive biases instead - these are systematic errors in judgement which can deviate us from rationality.

If you want to earn from the market, here are some cognitive biases to look out for:

I. The Dunning-Kruger Effect

Every investment textbook talks about the DK effect: the tendency people have to overestimate their ability, particularly when they are less competent. Most drivers think they are better than average; most gamblers think they are luckier than average. Because of this overconfidence, beginners at day-trading usually buy and sell way too often - they think they can read the market better than they can!

Why is this bad? Well, the hourly changes of the market are chaotic at best. You may plan to frequently buy at the bottom and sell at the top, but the market usually has a different plan.

Worse, victims of the DK effect are usually reluctant to learn. The false sense of control prevents them from forging a strategy, making it harder to update old beliefs, let alone to think rationally about the true reasons behind the rises and falls.

II. Confirmation Bias

Coming with the DK effect is the infamous confirmation bias: we pay selective attention to things that confirm our beliefs. Instead of being rational scientists who seek to disprove hypotheses, the confirmation bias turns us into conspiracy theorists who ignore unwanted evidence.

To profit from day-trading, we need to form rational judgements like a scientist, instead of only confirming our own beliefs like a conspiracy theorist. With the amount of information on the stock market, you can confirm pretty much anything.

More, psychologists have found that arguing for an opinion, can actually make you more certain about the opinion, even if the opinion is not yours! “Why would this stock grow? What’s my evidence? Is it valid? How long will it hold?” Asking these questions might help you to minimise confirmation bias and think more like a scientist.

III. Availability Heuristic

Since our brain has a limited cognitive capacity, we have evolved a short-cut, known as the availability heuristic: we tend to overestimate how frequent an event is based on the most salient available information. This means that rare events, recent events, and things that our friends do, will have a much greater influence on our thoughts.

Although Google's stock skyrocketed after its IPO is still fresh in our minds, that doesn’t mean that all IPOs grow like Google. In fact, PetroChina’s stock has been consistently falling since its IPO.

IV. Representativeness Heuristic

Another short-cut is the representativeness heuristics: we tend to interpret a signal as what it’s representative of in our minds, instead of what it most likely is. Basically, it means that we like to exaggerate signals while it could just be noise.

For example, we might interpret a slowing fall as a sign for reaching the bottom (what it’s representative of) instead of just a random fluctuation (what it most likely is). As a result, we buy in at the wrong moment. Same thing is true for interpreting fundamentals. These misinterpretations can really lead us into irrational trading decisions.

V. Ambiguity Aversion

Humans really don’t like ambiguities and uncertainties. It can make investors unwilling to diversify, because unfamiliar stocks make them feel insecure - while “buy what you know” has made Peter Lynch a great investor, it’s always good to use diversification as an opportunity to learn.

Alternatively, it can make us obsessed about predictions and ‘if-onlys’, simply because it feels good to believe in a version of the future, even if it will cost us our savings.

Another derivative of ambiguity aversion is ‘following the herd’. Since the market is so uncertain, our primal instincts direct us to follow others and stay warm in the herd. This can be a legitimate strategy called ‘momentum trading’, but without rational analysis of where the crowd is going, you might soon find yourself at the edge of a cliff.

Day-trading, like any other investment practices, requires lots of rational thinking. Knowing these common cognitive biases, you now know what to look out for when day-trading.

That’s why, it’s really important to “know thyself”; think about your own emotional stability, resilience and self-esteem, before planning on your capital size, leverages and when to cut your losses.

Perhaps, the greatest cognitive tool for any investor is a strong metacognition - the ability to see through why you are thinking and feeling the way you are. Knowing these cognitive biases, is one way to train your metacognition. With it, you can see through the Fear and Greed in the market, and capitalise on your cognitive edge.