Behavioral finance, 3 common biases and how to overcome them

[stockblogger]

Hello,
The article is long, so I will post it partly.

Representativeness Bias:

The Basics:


It’s common for every person to process new information, new phenomenon or some new idea through their past knowledge or experience. Many investors tend to evaluate the probabilities based on some past experience and they consider some company to be a good investment if it has performed well during some period in the past. Usually, it is the period, which is close to the present. Among many traders and investors, who are familiar to me, good past performance is a bullish sign. That’s clearly erroneous, leads to serious investment mistakes and thus to significant losses, instead of wishful profit. Also, when investor tries to classify some company and when it doesn’t suit to any of his categories, he tries to apply it to the category he thinks it best suits to, while it may really suit, BUT just PARTLY. Such investment mistake can drive to erroneous valuation and risk analysis.

Test:
1. Have you ever experienced a feeling of a strong wish to buy stock when you saw strong past performance?
2. If you have ever analyzed a stock analyst’s track record (and if he was successful), then did you decide to follow his recommendations?

If your answer is “yes” to both questions, then you are really susceptible to representativeness bias.

 

[stockblogger]

Sorry, forgot to post a link. here it is.

 

[stockblogger]

Feel free to express your opinion, say what biases you are susceptible to...

 

[lilduckling]

Quote from stockblogger:

Hello,
The article is long, so I will post it partly.

Representativeness Bias:

The Basics:


It’s common for every person to process new information, new phenomenon or some new idea through their past knowledge or experience. Many investors tend to evaluate the probabilities based on some past experience and they consider some company to be a good investment if it has performed well during some period in the past. Usually, it is the period, which is close to the present. Among many traders and investors, who are familiar to me, good past performance is a bullish sign. That’s clearly erroneous, leads to serious investment mistakes and thus to significant losses, instead of wishful profit. Also, when investor tries to classify some company and when it doesn’t suit to any of his categories, he tries to apply it to the category he thinks it best suits to, while it may really suit, BUT just PARTLY. Such investment mistake can drive to erroneous valuation and risk analysis.

Test:
1. Have you ever experienced a feeling of a strong wish to buy stock when you saw strong past performance?
2. If you have ever analyzed a stock analyst’s track record (and if he was successful), then did you decide to follow his recommendations?

If your answer is “yes” to both questions, then you are really susceptible to representativeness bias.

before i buy.... i have a mini court trial in my head. the stock or (entry if im doing YM).. if i intend on going long.... i act like a prosecuter and try to find as many reasons as i can NOT to buy... the stock has to prove itself well beyond any reasonable doubt..... or i dont buy. I do the reverse when shorting. I also used to apply this process to other things like services... but not any more.

 

[stockblogger]

Quote from lilduckling:

before i buy.... i have a mini court trial in my head. the stock or (entry if im doing YM).. if i intend on going long.... i act like a prosecuter and try to find as many reasons as i can NOT to buy... the stock has to prove itself well beyond any reasonable doubt..... or i dont buy. I do the reverse when shorting. I also used to apply this process to other things like services... but not any more.

You're right! That's very efficient way to overcome overconfidence. I use it myself

 

[PitchBlack]

Quote from lilduckling:

before i buy.... i have a mini court trial in my head. the stock or (entry if im doing YM).. if i intend on going long.... i act like a prosecuter and try to find as many reasons as i can NOT to buy... the stock has to prove itself well beyond any reasonable doubt..... or i dont buy. I do the reverse when shorting. I also used to apply this process to other things like services... but not any more.

This proves that you do not have clear rules ( or a clear system). If you would have clear rules, you wouldn't have to ask yourself all these questions. It would be clear: are the rules fulfilled or not?
That would be the only question.

What you do looks to me as gambling. You want to trade but you try to find reasons not trading. If there are not sufficient reasons for not trading you trade.
You should not look for reason for not trading, but for reasons to trade.

 

[lilduckling]

Quote from spike500:

This proves that you do not have clear rules ( or a clear system). If you would have clear rules, you wouldn't have to ask yourself all these questions. It would be clear: are the rules fulfilled or not?
That would be the only question.

What you do looks to me as gambling. You want to trade but you try to find reasons not trading. If there are not sufficient reasons for not trading you trade.
You should not look for reason for not trading, but for reasons to trade.

you did not understand my answer

this is not a substitute for my rules. it is an addition. there could be several stocks that fit my criteria..... that does not mean i buy them all

 

[MandelbrotSet]

Quote from lilduckling:

before i buy.... i have a mini court trial in my head. the stock or (entry if im doing YM).. if i intend on going long.... i act like a prosecuter and try to find as many reasons as i can NOT to buy... the stock has to prove itself well beyond any reasonable doubt..... or i dont buy. I do the reverse when shorting. I also used to apply this process to other things like services... but not any more.

Interesting post ... in some way, shape or form, I am confident D) that we all use a similar process when considering a trade (whether we have a systematic way of trading or a discretionary methodology).

Here's what I look at.

1. What is the trend on the higer time frame than the one that I am considering for entry?

2. What direction is price action moving in on the higher time frame?

3. What direction is price action moving in on the time frame that I am trading?

P.S. When it worksout, a trade feels smooth as silk. Even if price action bounces around on the lower time frame for a minute, so long as the higher time frame holds, I'm good.

 

[PitchBlack]

Quote from lilduckling:

you did not understand my answer

this is not a substitute for my rules. it is an addition. there could be several stocks that fit my criteria..... that does not mean i buy them all

With good rules or a good system you don't need any additions. Additions that are usefull will normally be part of the system or the rules you trade on.
If additions aren't part of the rules or system it means they are not good enough, why use them then?

 

[lilduckling]

Quote from spike500:

With good rules or a good system you don't need any additions. Additions that are usefull will normally be part of the system or the rules you trade on.
If additions aren't part of the rules or system it means they are not good enough, why use them then?

I stand by my methods. My approach may be totally different than yours. I am not day trading. I use top down approach .... starting with geo political atmosphere ..... economic cycle, sectors performance and related news to such. It is based on this approach that i use my mini court trial... to stocks that ALREADY fit my trading plan and entry criteria. I look for what sectors or industries are at play.... whether for long or short.... I then scan charts for several industries to see a set up... if i do.... I go down to scanning stock charts........ So sometimes I may have a stock under materials sector in possible play... and another one under the service sector........ well say we have any type of housing numbers due out the next day...... my final process would most likely end up going with the stock under service sector ... since I would try to find as many reasons as possible why i should not enter both ..............any way I like this technique ...I have been able to capture the best moves this way. Its very hard to put all this in a neat little box and call it a system...... since you have to have a certain ability to interpret world affairs that can affect prices both here and abroad.

Example... if China begins a major economic slowdown.... I then start scanning materials sector to look for possible industries (like steel for example) that are setting up for a short..... then go down to stock charts.
Here in the US... certain political policies
can affect stocks and industries. Especially Biotech.

Ofcourse my entry criteria is based ONLY on chart reading.

This works for me...... fits my style.