TRADING
These Two Cognitive Biases Are Why You Lose Money Trading Stocks
But can you avoid them?
Our brains are marvelous. They help us make intuitive sense of vast amounts of information in a way that computers can’t replicate.
Our brains are also flawed. They’re susceptible to cognitive biases: systematically incorrect perspectives that distort our view of reality.
Nowhere does this show up more dramatically than in the quick, high-stakes setting of trading stocks. Amid all the signals and noise, two cognitive biases threaten to undermine your account — and your peace of mind.
Underestimating the role of chance
We crave control, perhaps less to feed our egos (although it may) than to reduce the unsettling randomness and complexity around us. This craving is so powerful that we even find control where it doesn’t exist.
In the fantastic book A Random Walk Down Wall Street, Burton Malkiel describes an experiment in which participants played a game inspired by Pong.
A ball bounced back and forth between the sides of the screen. Subjects were told that some random things will affect the ball, but they could also click a controller to influence its movement. The twist was that the researchers sometimes disconnected the controller altogether…yet the participants didn’t catch on!
When disconnected, their actions had literally no effect, yet they reported a significant sense of control.
Now imagine if they had also invested lots of time and money in studying the ins and outs of this silly little game, and fancied themselves experts at it.
If totally naïve participants imagine some control, then self-styled experts probably imagine even stronger control, not weaker.
The author also described an experiment where he had students flip a coin to generate what look like stock charts. That’s pretty much the dictionary definition of a random process. Yet, when he showed one of the charts to a technical analysis expert, the expert thought the chart looked fantastically promising and recommended buying it ASAP.
The point isn’t that the chart lacked patterns. It had plenty. The point is that even this esteemed analyst totally wrote off the role of luck — which was, ironically, the only driving force.
This is an incredibly strong human tendency, and the fields of behavioral economics (however weak its credibility these days) and behavioral finance have replicated these sorts of results in a million different ways.
It’s hard to say why, and I’m unfortunately not going to resolve any existential dilemmas in this article.
But I will say that when you’re reviewing your own investments, or you’re evaluating some sort of course or trading signals or whatever product that purports to make you money…
The question is not “did this work?”.
It’s “did this work better and more consistently that chance alone could reasonably explain?”.
The answer might be frustrating and disappointing, but I’d contend that it’s nowhere near as frustrating or disappointing as the financial and psychological cost of underestimating the role of chance.
Overestimating likelihood
Oddly, as easily as we overlook the role of chance, we’re also eager to assume luck is shifting in our favor.
That’s strange, but we’re complicated creatures, aren’t we?
It’s easy to find all sorts of probability figures around literally anything related to the stock market. But they’re all pretty abstract, so I sometimes find it more helpful to think about risk in terms of how many assumptions beyond my control I need to be right about.
That’s not quantitative, but it’s a good way to build intuition around how likely you are to actually make or lose money. As your assumptions get more numerous or specific or unprecedented, there’s more than needs to work out in your favor, and therefore more risk.
With $10 million in assets, I’d need just 0.365% annual returns to earn $100/day. Simply putting that in the bank would do the trick. My only big assumption? There won’t be a run on the bank, and interest rates won’t go to zero…again.
(There are other technicalities, like FDIC insurance limits, but stay with me here.)
We’re assuming so little that it’s hard not to get it.
But what if I wanted that same $100/day equivalent from a classic dividend stock like Coca-Cola? They pay roughly 3%/year these days, which is a whole lot more than the bank pays, so we’d need just $1.2M upfront.
However, I also need bigger assumptions to work out in my favor: namely, Coca-Cola needs to maintain its decades-long streak of steady dividends. Their dividend payout history is famously consistent, and far less fickle than something like share price, but it’s far from the certainty of interest payments on a savings account.
We’re still not assuming a ton, but it’s a good deal more than before.
Next, let’s turn up the risk dial and start selling cash-secured put options in order to squeeze that same $100/day out of $360,000 in starting capital. In this case, we profit as long as the stock price doesn’t fall sharply. That’s not an extremely bold assumption — like trying to say what the price will do — but it’s still harder to be correct about that than about Coca-Cola paying another dividend.
Upping our assumptions and therefore risk even further, we could buy call or put options expiring in a week. Now, we have to be right about what the share price will do and by when it will do it. If we’re right, the upside is enormous. If we’re right.
I trust you see the pattern. We’ve got from merely needing the world as we know it continuing to function (i.e., the near-certainty of savings account interest) to needing to predict time-constrained future price movements (i.e., our long options positions).
Obviously, our target returns increase along that risk continuum.
But too many investors lose sight of the extent and contingency of their assumptions. They degenerate into gamblers without realizing it.
Again, this isn’t a mathematical approach to risk, but I’d argue that this lens of assumptions and dependencies is every bit as valuable for everyday investors. Not only does it help you just stop doing dumb things in the market, but it also strengthens your B.S. detector around claims of guaranteed this or risk-free that.
Conclusion
When we leave chance unacknowledged, it eats our profits (and even livelihood) from both ends. That’s obvious. What’s less obvious is how luck enters the picture, and therefore how to work with or around it.
First, remember that you almost certainly control less than you think you do. It’s a strong, nearly universal, human tendency. We crave the certainty of control so badly that we invent it where it never existed in the first place.
Second, we quantify risk with potentially misleading precision, yet ignore the simple question of how many things we need to be right about (and how many dependencies are built into them).
These realities won’t transform you into Warren Buffett, but I suspect they’ll keep your losses from losing your shirt.
