common thinking errors

Discussion in 'Psychology' started by fhl, Nov 24, 2007.

  1. fhl


    Here are some common thinking errors that impact your trading:

    1) Confirmation Bias

    The confirmation bias is a tendency to seek information to prove, rather than disprove our theories. The problem arises because often, one piece of false evidence can completely invalidate the otherwise supporting factors.

    Consider a study conducted by Peter Cathcart Wason. In the study, Wason showed participants a triplet of numbers (2, 4, 6) and asked them to guess the rule for which the pattern followed. From that, participants could offer test triplets to see if their rule held.

    From this starting point, most participants picked specific rules such as “goes up by 2“ or “1x, 2x, 3x.” By only guessing triplets that fit their rule, they didn’t realize the actual rule was “any three ascending numbers.” A simple test triplet of “3, 15, 317“ would have invalidated their theories.

    2) Hindsight Bias

    Known more commonly under “hindsight is 20/20“ this bias causes people to see past results as appearing more probable than they did initially. This was demonstrated in a study by Paul Lazarsfeld in which he gave participants statements that seemed like common sense. In reality, the opposite of the statements was true.

    3) Clustering Illusion

    This is the tendency to see patterns where none actually exist. A study conducted by Thomas Gilovich, showed people were easily misled to think patterns existed in random sequences. Although this may be a necessary by product of our ability to detect patterns, it can create problems.

    The clustering illusion can result in superstitions and falling for pseudoscience when patterns seem to emerge from entirely random events.

    4) Recency Effect

    The recency effect is the tendency to give more weight to recent data. Studies have shown participants can more easily remember information at the end of a list than from the middle. The existence of this bias makes it important to gather enough long-term data, so daily up’s and down’s don’t lead to bad decisions.

    5) Anchoring Bias

    Anchoring is a well-known problem with negotiations. The first person to state a number will usually force the other person to give a new number based on the first. Anchoring happens even when the number is completely random. In one study, participants spun a wheel that either pointed to 15 or 65. They were then asked the number of countries in Africa that belonged to the UN. Even though the number was arbitrary, answers tended to cluster around either 15 or 65.

    6) Overconfidence Effect

    And you were worried about having too little confidence? Studies have shown that people tend to grossly overestimate their abilities and characteristics from where they should. More than 80% of drivers place themselves in the top 30%.

    One study asked participants to answer a difficult question with a range of values to which they were 95% certain the actual answer lay. Despite the fact there was no penalty for extreme uncertainty, less than half of the answers lay within the original margin.

    7) Fundamental Attribution Error

    Mistaking personality and character traits for differences caused by situations. A classic study demonstrating this had participants rate speakers who were speaking for or against Fidel Castro. Even if the participants were told the position of the speaker was determined by a coin toss, they rated the attitudes of the speaker as being closer to the side they were forced to speak on.

    Studies have shown that it is difficult to out-think these cognitive biases. Even when participants in different studies were warned about bias beforehand, this had little impact on their ability to see past them.

    What an understanding of biases can do is allow you to design decision making methods and procedures so that biases can be circumvented. Researchers use double-blind studies to prevent bias from contaminating results. Making adjustments to your decision making, problem solving and learning patterns you can try to reduce their effects.

  2. Nice post.

    It's all about basic logic...
    Being TRAINED to think logically and critically.

    The BIG mistake people make:

    I have high IQ... therefore I think logically and critically.

    Nothing could be further from the truth...
    Only a few hardcore disciplines TRAIN highly intelligent people to think logically.
    Law school is a good, non-math example.

    You don't see lawyers falling for the idiotic stock market scams...
    That so many people here are obsessed with.

    I can assure you that ZERO lawyers watch Cramer...
    Because he's so laughably a con artist...
    And part of an industry full of con artists.

    I can also assure you that close to ZERO lawyers day trade...
    Because it's illogical to believe Amateurs can take money away from Professionals...
    Or that the financial markets are not rigged against Amateurs.

    But, ultimately, it just doesn't matter.

    Greed and fantasy will always trump rational analysis for most.

    For every Star...
    There are 1,000 people who believe they will be a Star...
    Of which 999 will never become a Star.
  3. Good posts - the only part I object to is the bit above, and only the first sentence. I have no problem believing that pros have a bunch of different ways to relieve newbs of their money. Just look at forex.

    However, anyone who has sat in front of a 3-minute chart for a few days can see that there is nothing stopping anyone from buying or selling at the right time. Of course most newbs don't, but in my personal experience, there was nothing and no one forcing me to hit the button. Anyone fading my losers would have had... winners!

    I would say it's illogical to believe that it's impossible for a non-pro to take money out of the markets.

    I also agree strongly about the lack of correlation between IQ and trading success.
  4. You don't see lawyers falling for the idiotic stock market scams...


    Why should they when they can create them. Milberg Weiss comes to mind.
  5. Psychology 101:

    Lawyers are highly intelligent logical thinkers who without exception refrain from making common mistakes.

    Is this statement biased yes/no?

    - Now excuse me while I go cry myself to sleep on my little pillow for not going to law school and become God.
  6. maxpi


    I am sure that when an "amateur" takes away money from the markets consistently that he would be considered a pro! :D Therefore it is logical to say that amateurs can't take money away from pros!!
  7. There is a post on my blog about having a Bias

    and I did a you tube video about Behavioral Trading

    I feel that emotions is the # 1 Reason traders fail to be consistant with there profits, there are so many issues we face every day, we must remain natural in order to take advantage
    of this market volatility.

    If you have not read Mark Douglas " Trading in the Zone"

    check it out

    Take Care,

    Joe Baker
  8. Law school...
    Was identified as just ONE "non-math" example...
    Of a high IQ cohort... that is specifically trained to think in a structured, logical manner...
    Or you will fail to graduate.

    More examples of logical training:

    (1) Computer Science
    (2) Hardcore Engineering Programs
    (3) Math/Stats
    (4) Medical/Dental School
    (5) Very select graduate economic programs (quant stuff, but definitely not MBA)
    (5) Graduate level Philosophy (non-math)
    (6) At least 2-3 years of winning Pro Tournament Poker.

    If you go to the any Futures Pit...
    A vast majority of the top people...
    Will have a mixed background from that list.

    My math/strategic analysis IQ in high school was measured as >>> 99th percentile...
    But without graduating from a KILLER Computer Science program...
    I could NEVER have become a successful trader.
  9. I tend to think of Pros...
    As people who run a ** trading business ** for decades... for life...
    In a business-like manner with all the necessary infrastructure...
    Capital, technological, administrative, regulatory infrastructure.

    Someone with 5 figures in capital...
    With a $3,000 annual tech budget...
    Who trades from home... or on his cellphone while skateboarding...
    Is someone who ** aspires ** to be a "professional".

    We will see what that person is doing in 10 years...
    But > 90% chance it will be something else.
  10. The OP listed seven common mistakes that cause market participants to enter into losing agreements. The list is valid and avoiding these mistakes is a great step towards profitability. It's a myth that someone carrying a degree in a hard science will be less prone to make those mistakes. Just because someone carries a degree from an institution that you hold in high esteem doesn't guarantee that they don't move through life like Basil Fawlty. Such a belief will suprise you on the downside.

    #10     Nov 25, 2007