REAL WORLD
Getting Past Representativeness
Overcoming Biases
by Gary Norden
Trading biases may be affecting your decision-making abilities. Being aware of them can help you overcome them.It has always amazed me how, in a business in which we essentially have a 50% probability of making money, about 80% of private traders lose. In the futures market where technical analysis is more prominent, the failure rate is even higher -- more than 90%. Could it be that a majority of traders are doing something drastically wrong?
WHAT ARE TRADERS DOING?
From my experience as a local trader on LIFFE, running investment bank trading desks, and from conversations with traders and brokers around the world, I have reached the conclusion that the biases and rules of thumb -- like anchoring, conservativeness, and loss aversion -- described by behavioral finance supporters are good examples of where traders go wrong. More likely than not, traders are prone to one or more of these biases, which can result in irrational and poor decision-making. In order to improve your trading, you must first of all recognize these biases before you can overcome them.
One such bias that I believe affects those who use technical analysis is the representative bias. Those prone to it will estimate the likelihood of something happening based on how closely it resembles something else, whether it is proven information, useless "noise," or something that has previously happened. Yale economics professor Robert Shiller summed up representativeness by explaining that "...people tend to make judgments in uncertain situations by looking for familiar patterns and assuming that future patterns will resemble past ones, often without sufficient consideration of the reasons for the pattern or the probability of the pattern repeating itself." Translated to the market, this can lead traders to place too much emphasis on recent history without analyzing the context of the move or the probabilities of future movements. Traders tend to look at the recent trend and expect it to continue without analyzing it further.
...Continued in the May issue of Technical Analysis of STOCKS & COMMODITIES
Excerpted from an article originally published in the May 2005 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2005, Technical Analysis, Inc.
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