Ever wonder why bubbles happen? Or why listening to gurus while you trade doesn’t seem to improve your performance? Availability bias has a lot to do with both these issues, and is a very common hindrance for traders.
In this trading psychology article, we’ll look at Availability Bias in trading. As the name implies, it’s a bias we hold internally which affects our actions, but of which we’re often unaware. If we look closely we can see the symptoms of the bias in certain trading tendencies, and once we have isolated the symptom/problem we can dig deeper into the cause.
Trading Psychology – Availability Bias in Trading
An availability bias is when we assign a probability to an outcome based on how many examples we can think of, or assign probability based on the most accessible data. An example was provided in What are the Odds Probabilities in Trading are Calculated Wrong?
Are there more six-letter words in the English language where the 5th letter is an n, or more six-letter words in the English language that end in ing?
Instantly the brain goes to work and thinks of many words ending with “ing.” So there must be more words that end within “ing”!
Not so fast.
The mind has taken a shortcut; just because it’s easier to think of words ending with “ing” doesn’t mean it’s more common than the “n” being the fifth letter. In fact, all 6 letter words ending in “ing” will have “n” as the fifth letter. Therefore, there are more six letter words with “n” as the fifth letter.
This example is fairly easy to spot, and makes sense of once explained. But other availability biases are much harder to see. This is especially true in trading because people get very passionate when money, reputation and credibility (who’s right?) are on the line. Beliefs and biases that are easily dis-proven are clung to, defended using logical fallacies and passed along as stone-cold truth.
Availability Bias in Trading: Financial News
Does the stock market work on a cause-and-effect basis? For example, if there is positive news about the economy today, will stocks rise?
Conventional wisdom says yes. Positive news releases lead to positive stock performance, and negative news to poor performance. The media reinforces this everyday. Here a few headlines I saw over two days writing this article (originally written Nov, 2013):
-Stocks Close Lower as Yellen Testimony Looms – Yahoo! Finance
-U.S. stocks dropped as investors locked in gains amid Fed expectations – LinkedIn
-S&P 500 Climbs to Record as Macy’s Jumps Amid Fed Bets – Bloomberg
It definitely seems like there is a cause and effect relationship between stocks and the positivity or negativity of news events–or at least the writers believe so. But this too is an availability bias and it will lead you astray.
An availability bias is when you come to a conclusion based on information you see most often, but may not necessarily be the most accurate information. Occasionally the information you see most often will be accurate, but usually there is an inherent bias.
News writers are trying to rationalize market movements based on events that occurred that day. All this proves is that a market movement occurred at roughly the same time as a news event, but it does not prove a cause-and-effect relationship. Also, the very reason spouted for a market movement today, will be used another day to rationalize a market movement in the other direction.
Speculation on the Fed decision was used to rationalize a stock market fall one day, and a rise in the stock market the next. Such headlines are useless and add nothing to the world of market knowledge or study, and in fact may lead readers into believing that uncertainty heading into a Fed decision could make stocks rise, or fall,with some certainty…and that’s just not the case.
All these writers and traders who base their market opinions on articles (or form similar stories inside their own head) such as these are falling into an availability bias. They see cause and effect articles constantly, and therefore believe it is true. It may occasionally be right (randomness), but it is far from a good form of analysis. See: The Stock Market is Not Physics Part III.
When stocks are rallying like crazy, you’ll see loads of articles all trying to explain why stocks are flying higher. You’ll come to the “obvious” conclusion that buying stocks is the best thing to do. And maybe it is for a time, but even when stocks start to drop, you’ll still have all those reasons in your head about why owning stocks is so great. Since very few people are putting out warnings just after a market top, you draw conclusions based on the most available information….which is still “BUY BUY BUY!”
The danger is that you aren’t looking at what is actually going on in the market. Instead, you have chosen to rely simply on what you hear and read most often (or your beliefs), which may not be an accurate representation of what is currently happening.
An even broader availability bias is that traders may begin to think they need the news (or other people’s opinions) to trade. After all, financial news is pumped out all day on business news channels and on thousands of financial news websites. “It must be important!” Some traders may use the news to trade successfully, but the premise that you need to trade with a constant news feed–simply because it is so readily available–is false.
Availability Bias in Trading: Trading Success and Failure
Consider other things you hear and see often. For example, you may read trading forums and only see posts on how much money everyone has lost trading. You begin to believe that there is no money in trading anymore, and as a result of your (now) more pessimistic belief your own trading performance begins to suffer (it could be the market, maybe not. The real question to ask is “Are other people’s views affecting me adversely?”). Or, if you are new to trading, you may deem the endeavor impossible–based on all these negative reports–and thus never give it a try.
On the other hand, you may see loads of articles and watch YouTube videos about novice traders becoming millionaires overnight. Since this information is so readily available to you, you begin to believe you can amass a trading fortune quite quickly as well….possibly at great financial consequence. In both cases there is an availability bias. You’ve drawn conclusions based on how often you see or read something, and not whether it is factual or representative of actual probability. Here are some stats on how many day traders succeed and how long it takes to gain consistency.
Another availability bias that seems prevalent among some so-called-professionals and novices alike is “Trading is much harder today than it was before; high frequency traders/institutions will eat you alive [or fill in any common excuse here].”
Trading has always been hard (we still study former crashes because they wiped so many people out), but there are easier times and tougher times. During a raging bull market anyone can buy and then sell a little while later to make money. So it is true that even the best traders will have better times and worse times, but does that make the belief statement above true? Not necessarily. This belief is created by the amount of information pumped out about high-frequency trading, usually in a negative tone, people remembering the flash crash and commenting about it, and it makes a great excuse for those who aren’t making money.
Market conditions do change, and that IS what makes being a consistently profitable trader so difficult. Each trader needs to find a way to capitalize during the good times, but avoid damage in the tough times. It is a repeating cycle.
Related to this topic is “survivorship bias.” With all the trading, analysis, news and signal websites/papers/books/articles and videos it makes it appear that there are vast amounts of successful traders. This may lead to believing it’s easy to trade; much of the marketing related to these media sources encourages this belief. Yet simply because there are lots of trading sites/books/etc does not mean it is easy, or that the vast majority of those who attempt trading end up succeeding. This is an availability bias based on survivorship–those who fail don’t usually put up websites or write books admitting it. The plethora of information is mostly skewed one way–one guy may hate day trading, but advocates swing trading or investing. Either way, the information points you toward opening a trading account.
When you seek something out, you will find it. When searching for information, don’t only research what you already believe to be true, research evidence to disprove it.
Availability Bias In Trading: Trading Cliches
Consider these trading cliches you hear often: the trend is your friend, let your profits run, keep your losses small, only take trades with a good risk/reward ratio.
If you read financial news or watch a financial news network you’ll hear at least 50 trading cliches a day. They sink into your head without you even realizing it. You hear them so often that they slip into your subconscious unquestioned, lying dormant until one it pops up to sabotage your trading plan.
I always take my profits within a fixed target range. That’s my strategy, it works for me and I stick to it. But occasionally the idea pops into my head “let the profit run.” If I listen to the voice, sometimes I may end up with a larger profit, other times a smaller profit. But that is not the point. “Let the profit run” is unquantifiable, therefore un-testable and only serves to deviate me from my plan. It doesn’t tell me where to get out, when to get out, how long I let it run (till it turns into loss???) or what criteria I should use to eventually exit. It is advice that is highly available, but creates a bias under which the parameters of your trade go from known to unknown.
Some of these cliches may have good advice hidden within them, but only when applied to a personal context, in a planned way. If I notice that my profits are getting smaller, I may choose to revise my system to try to capture larger profits. But such changes need to undergo a testing phase, whereas simply deciding arbitrarily to let a profit run is untested, undisciplined and irresponsible.
Very often we fall prey to the information that is most readily available, but which isn’t in our best interest at the time.
Overcoming Availability Bias In Trading
It is impossible to rid ourselves of all availability biases in our lives–I am writing this under the influence of biases.
In order to function and not go completely crazy we need to draw conclusions quickly, and sometimes that means trusting something or someone without verification. Plus, there isn’t enough time to verify everything we see or hear.
In trading though, an availability bias can hurt you and take your money. This is why developing your own personal trading style is important. You may use someone else’s strategy as a template, but you have to thoroughly understand it–its advantages and disadvantages–and then make it your own by customizing it to your personality, tendencies, lifestyle, resources, risk tolerances and time frame (see Find the Right Trading Mindset–Dependent or Independent).
If you find you are being sabotaged by other people’s opinions on the market, or some cliche you keep reading in books, the best solution is to avoid that which is sabotaging you. If you find it hard to focus on your strategy while all the talking heads on CNBC are providing their opinions, then don’t watch CNBC. After all, you don’t need to watch the news to be a good trader.
Don’t rely on what you see or hear, regardless of the source. Try it out for yourself, verify it and then work out ways to implement it. This is why I recommend all traders spend at least several months in a demo account when learning the strategies discussed on this site. You need to learn how YOU can implement them. It is likely that you and I are very different people, see the world in different ways, and may interpret information in different ways. What I do works for me, and if you opt to use my methods it is up to you to make them work for you.
Remember, just because you see something a lot does not mean it is what is best for you, or even true.
At the start of the article I indicated that the availability bias can be linked to bubbles. You may understand how that is possible now based on a few of the examples. If not, you can read more about it here: Why Most Traders Lose Money and Why the Market Requires It
If you have encountered, or can think of, availability biases that have/do/might affect your trading, please share.
By Cory Mitchell, CMT
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