How does the representational heuristic bias affect your behavior from a psychological perspective?

2022-04-25 0 By

Representational heuristic bias is very common among traders.In each case, traders assumed certain features of the market were real when they were not.It starts when we replace difficult tasks with easy ones.We can see in cases where a representative heuristic bias occurs when a trader identifies a chart pattern, indicator or price movement and compares it to a prototype, assuming that the similarity is sufficient to make a trading decision, when in fact the trader needs to perform a more deliberate analysis.At such times, traders ignore the most likely course of action, the base probability.We choose to focus on the often salient data, exclude other relevant data from consideration (what you see is the big picture), and place too much weight on recent events in our decision-making process.In addition, when things are going well and we feel good, we may be careless, which is a big no-no in trading in the market.Sometimes the representational heuristic bias is more subtle.Michael Cooper, a professor at the University of Utah’s Eccles School of Business, has done interesting research on representational heuristic bias.For example, during the bull market bubble of the late 20th and early 21st centuries, the Internet was an exciting novelty.Cooper and his colleagues found that companies that simply changed their names and added the word “.com “to their names significantly outperformed other stocks during that period.Traders and investors apparently believe that a stock name alone represents a company that is well managed, has a large market share, is well capitalized, has a business plan, and has a profitable and sustainable product or service line.Interestingly, Cooper went on to do the same research after the dotcom stock bubble burst.It is easy for representative heuristic biases to sway investors and traders, as the research team tracked companies that subsequently removed “.com “from their names and found surprising stock price increases in the two months following the name change.· More heuristic bias and Cognitive bias Representative heuristic bias is probably the most common heuristic bias seen by traders.In addition, psychologists have found many other heuristic and cognitive biases.Wikipedia, for example, lists more than 90 biases related to judgment and decision making (some are limited to specific social situations, others to recall).Keeping track of all the biases and heuristics psychologists have found can be a maddening task.But you need to be aware of some common biases and how they can hurt your trades.Here I highlight a few of the most relevant biases for trading, with others to be discussed in later chapters.Confirmation bias After making a hypothesis, people tend to seek to confirm their hypothesis rather than disprove it.So instead of looking for data that contradicts it (for example, information that would make us question a trading assumption), we naturally tend to look for data that is consistent with our views, that supports our views, and place undue importance on them.We have a strong need to prove ourselves right, to confirm what we already know or believe.This phenomenon is known as “confirmation bias” and is a significant cause of trading difficulties.A technical trader who uses the Stochastic Index as the primary indicator to assess overbought/oversold conditions is considering whether to make a trade and, “just to be on the safe side,” decides to also look at the CCI Commodity Channel Index, a confirmation bias.Both measures measure roughly the same characteristics of price movement, giving traders the same information.Not only is the trader making decisions based on two methods that are inherently relevant, but she falls into a mental trap: since both indicators send signals, she assumes the signals are stronger, so this must be a good trading opportunity.As a result, she may become overconfident and take irrational actions, such as adding to a position or holding it too long, both of which can cause significant losses.Focusing solely on confirmation data can also lead to losses larger than planned when the market turns against the position.In this common example, the trader continues to focus on and overestimate signals supporting continued exposure, ignoring the threat of loss.Therefore, even if the position has been lost, traders will still pay too much attention to the small price movement that appears to be beneficial to the position alone, used to confirm the original trading reason, and ignore or ignore the significant price movement that is unfavorable to the position.In this case, instead of objectively assessing the unfolding of the market and closing the position early, the trader is out of the stop (if any).Typically, however, traders do not post stop-loss orders at all in the event of a confirmation bias, and only close the trade when the trade is so bad that the trader can no longer bear the pain of further losses.George Soros, the legendary trader, once said that traders’ ability to sift through data for disinformation is rational behavior that generates profits.However, the search for falsified data is unusual and goes against our nature.Judgment and decision experts Edward Russo and Paul Shoemaker say confirmation bias is a psychological reinforcement.When we find confirmation signals that we’re right, it makes us feel good about ourselves and happy.No wonder intuitive minds prefer data that can easily and quickly prove a trading idea or market bias.Proving that we are right can reinforce our good feelings so that we can’t get rid of this bias.If we seek, find and accept false evidence, we are saying that we have made a mistake.Most people don’t do this naturally.It also requires active deliberation, which, as we have learned, is no easy task.No wonder Mr Soros says the ability to find disinformation is rare and valuable.Recency effect We’ve already talked about recency effect.But since this issue has a significant impact on transactions, it’s worth going into more detail here.The recency effect works because we tend to place more weight on recent events, even when other data may be equally or more important.What has just happened remains fresh in our minds more deeply than what happened earlier.Since the mind attaches more importance to recent events, this can also affect our expectations for the future.Whether a trade is profitable or loss-making, recent experience can have a big impact on a trader’s psyche.The trader seems to assume that the outcome of the recent trade A will directly affect the outcome of the future trade B.We know (or should know) that this isn’t true.Each transaction is independent and does not interfere with each other.Transaction A does not affect transaction B, but because of this cognitive failure, we act as if there is A connection.Traders are influenced by the recency effect (a psychological blind spot).When looking at a chart, novice traders (and even many experienced traders) will immediately look to the right of the chart to see the last few K-lines and quickly determine the future direction of the market based on limited information.Intuitive thinking likes this, picking out a few data points, evaluating them quickly, making decisions, and evaluating trades based on recent market behavior as the only important basis, regardless of other background conditions and overall market conditions.As a result, traders are likely to make trading decisions based on random information.Due to recency, we tend to ignore market conditions and background data and focus on updated information rather than more relevant information.We attach too much importance not only to recent external events, such as market performance or entry patterns, but also to our trading performance.If we trade well, have a string of successful trades or outperform, we may be affected by our recent experiences.We tend to think we’re hot, or that our skills and abilities are somehow improving quickly, or that our ability to read the market is better than others.As a result, we can make unforced trading errors, such as adding positions, overtrading, or reluctantly trading when entry conditions are not fully met.This emotional heuristic bias — taking things easy because you feel good about yourself — may reinforce and amplify recent good performance.Too much emphasis on recent performance can affect our current attitudes and behaviors, often leading us to deviate from our trading plans and, more often, from rational trading.Traders tend to overvalue not only profit performance but also loss performance.Traders who have underperformed recently may therefore exit the market to avoid expectations of further underperformance, or, conversely, increase their losses or make additional trades to recover their losses.However, it is important to note that traders attach too much importance to recent events or actions, directly affecting their next move.This often leads to erratic trading behavior, an increased chance of making unforced trading errors and unnecessary losses.