#anchoringbias

[bodyofbrilliance]

Unveiling the Minds Tricks: Exploring Cognitive Biases in Everyday Life

Unveiling the Minds Tricks: Exploring Cognitive Biases in Everyday Life

Understanding Cognitive Biases: How Our Minds Deceive and Play Tricks on Us Our brains are incredible machines, capable of processing vast amounts of information and making split-second decisions. However, they are not without flaws. Have you ever made a decision that, in hindsight, didn’t seem to make much sense? Or believed something that was clearly not true? You’re not alone. We all…

[marketwizards]

The Psychology of Risk Management in Trading: An In-Depth Exploration with Real-World Examples

Risk management is a critical component of any successful trading strategy. It involves understanding, assessing, and mitigating the risks associated with trades to ensure long-term profitability and protect capital. While technical analysis, market knowledge, and sound strategies are essential, the psychological aspect of risk management often determines a trader's success or failure. This essay delves into the psychological factors behind risk management, exploring how traders can develop a mindset that enables them to handle risk effectively. We will also examine real-world examples that highlight the role of psychology in trading success.

1. The Importance of Risk Management in Trading

Trading is inherently risky. Markets are influenced by numerous variables, including economic data, geopolitical events, and investor sentiment, all of which can change rapidly. Proper risk management ensures that traders can weather losses and capitalize on opportunities while protecting their capital from catastrophic declines.

A. Capital Preservation

At the heart of risk management is the concept of capital preservation. Experienced traders understand that the primary goal is not to make money quickly but to survive in the market long enough to grow their capital steadily. Without proper risk controls, even a string of profitable trades can be undone by a single large loss.

Example: The collapse of LTCM (Long-Term Capital Management) in 1998 serves as a classic example. Despite employing some of the brightest minds in finance and having access to sophisticated mathematical models, LTCM failed due to poor risk management. Their highly leveraged positions magnified their exposure to market volatility, and when markets moved against them, the losses were catastrophic. This illustrates the danger of not adhering to disciplined risk management, even for institutional traders.

B. Risk-Reward Ratio

One of the most fundamental principles in risk management is the risk-reward ratio. This refers to the potential profit of a trade compared to its potential loss. A trader must assess whether the potential reward justifies the risk. A common guideline is to aim for a risk-reward ratio of at least 1:2, meaning that for every dollar risked, the potential reward should be two dollars.

Example: Consider a forex trader who places a trade on EUR/USD with a stop-loss of 50 pips and a target of 100 pips. If the trader wins, they gain 100 pips, but if they lose, they only lose 50 pips. This is a risk-reward ratio of 1:2, which, over time, increases the chances of profitability even if the win rate is not exceptionally high.

2. The Role of Psychology in Risk Management

Successful risk management goes beyond calculations and strategy—it is deeply rooted in psychology. The ability to handle uncertainty, control emotions, and stay disciplined is what separates professional traders from amateurs.

A. The Fear of Losing

One of the most pervasive psychological challenges traders face is the fear of losing. This fear often leads traders to hold onto losing positions for too long, hoping the market will reverse, or to exit winning positions too early to lock in small gains. This behavior undermines sound risk management principles and leads to inconsistent performance.

Example: In the world of retail trading, this fear of losing is common among beginners. A trader may enter a position on a stock, watch it dip slightly, and then panic and close the trade at a small loss, only to see the stock rebound shortly after. By not adhering to their original stop-loss, they miss the potential gains, driven by fear rather than logic.

B. Overconfidence and Greed

Conversely, overconfidence and greed are psychological traps that can also lead to poor risk management. After a series of successful trades, traders may increase their position sizes without adjusting for risk, believing that they have a foolproof strategy. This can lead to significant losses when the market inevitably turns against them.

Example: The dot-com bubble of the late 1990s provides a stark example of how greed can influence risk-taking. Many investors and traders ignored traditional valuation metrics and poured money into technology stocks, believing they could only go higher. When the bubble burst in 2000, billions were lost, and many traders saw their portfolios wiped out due to excessive risk-taking and a lack of discipline.

C. The Impact of Loss Aversion

Loss aversion is a well-documented psychological phenomenon in which the pain of losing is felt more intensely than the pleasure of gaining. This can lead traders to avoid closing losing positions, hoping they will turn around, rather than accepting the loss and moving on. Loss aversion often leads to greater losses, as small losses accumulate into large ones when positions are held too long.

Example: A trader may enter a position expecting a stock to rise but sees it decline steadily. Instead of adhering to their stop-loss, they refuse to close the position, hoping for a reversal. The stock continues to fall, resulting in a much larger loss than initially planned. This inability to accept small losses is a hallmark of loss aversion and a significant barrier to effective risk management.

3. Techniques for Overcoming Psychological Barriers

To manage risk effectively, traders must develop psychological resilience and discipline. Several techniques can help traders overcome the emotional challenges of risk management.

A. Sticking to a Trading Plan

One of the most effective ways to mitigate emotional decision-making is to follow a predefined trading plan. A solid trading plan includes entry and exit criteria, position sizing rules, and risk management guidelines. By having a plan in place, traders are less likely to make impulsive decisions based on emotions.

Example: A day trader may decide in advance that they will risk no more than 1% of their account on a single trade and will only enter trades that meet specific technical criteria. By sticking to these rules, they can remove emotional biases from their decision-making and ensure consistency in their approach.

B. Use of Stop-Loss Orders

Stop-loss orders are an essential tool for risk management. A stop-loss order automatically closes a trade when a predetermined price is reached, limiting the potential loss. By using stop-losses, traders can ensure they do not hold onto losing positions for too long, even when emotions are running high.

Example: A forex trader enters a long position on the USD/JPY pair, setting a stop-loss 50 pips below their entry price. If the market moves against them, the trade is closed automatically at the stop-loss level, preventing further losses. This removes the emotional temptation to hold onto the trade in hopes of a reversal.

C. Position Sizing and Diversification

Position sizing is another critical aspect of risk management. By carefully determining how much of their capital to allocate to each trade, traders can protect themselves from significant losses. Diversification—spreading risk across different assets—can also help reduce the impact of any single trade or asset's performance on the overall portfolio.

Example: An options trader might decide to risk only 2% of their capital on any single trade. Additionally, they may diversify by trading multiple assets, such as equities, forex, and commodities, rather than focusing on one market. This reduces the risk of a single market event wiping out their entire portfolio.

D. Managing Expectations and Accepting Losses

Traders must accept that losses are a natural part of trading. By managing their expectations and understanding that even the best traders experience losses, they can maintain a balanced mindset. Accepting losses as part of the process helps traders avoid emotional reactions that can lead to poor decision-making.

Example: Paul Tudor Jones, one of the most successful hedge fund managers, is famous for his strict adherence to risk management. He often reminds traders that protecting capital is more important than chasing profits. His success is largely due to his ability to take losses quickly and move on to the next opportunity, rather than allowing losing trades to spiral out of control.

4. Real-World Examples of Effective Risk Management

Several high-profile traders and investors have demonstrated the importance of psychological resilience and disciplined risk management.

A. Ray Dalio and Bridgewater Associates

Ray Dalio, the founder of Bridgewater Associates, one of the world’s largest hedge funds, is known for his focus on risk management. Dalio emphasizes diversification and risk parity, spreading risk across asset classes to protect the fund from extreme market events. This approach allowed Bridgewater to weather the 2008 financial crisis with minimal losses while many other hedge funds collapsed.

B. Stanley Druckenmiller

Legendary trader Stanley Druckenmiller credits his success to being disciplined in risk management. Druckenmiller once said that he believes in taking large positions when the odds are overwhelmingly in his favor but exiting quickly when the trade goes wrong. His ability to recognize when a trade isn't working and cut losses has been a hallmark of his success over decades.

Conclusion

The psychology of risk management in trading is as important, if not more so, than the technical aspects of any strategy. Traders who master their emotions, stick to disciplined risk management principles, and accept losses as part of the process are more likely to achieve long-term success. By using tools like stop-loss orders, following a trading plan, and managing position sizes effectively, traders can mitigate risk and stay in the game. However, without the right mindset, even the most sophisticated strategy can fail. Successful traders understand that the market is unpredictable, and the key to thriving in it is psychological resilience and disciplined risk management.

[20westlegal]

Did you know that sometimes our brains can trick us into making not-so-great money choices?

This can happen because of something called "anchoring bias." That's when the first thing we hear or see sticks in our minds and influences our decisions later on. Like when a number gets stuck in our heads and affects how we think about money.

Here are some ways anchoring bias may play a role in your financial life. https://bit.ly/anchoringbiascanhurtyou

[brightinsights]

The Power of Anchoring Bias: How It Shapes Our Decisions #shorts Discover how the anchoring bias influences our choices, from pricing to job negotiations. Learn why our brains rely on mental shortcuts and how this affects our decision-making process. Unlock the hidden powers of your brain!#AnchoringBias #DecisionMaking #CognitiveScience #MentalShortcuts #BrainPower https://www.youtube.com/watch?v=3WlFI5m6bKc via BRIGHT INSIGHTS https://www.youtube.com/channel/UCJ6Vnlt6GxPk2SM59r_YByQ April 11, 2025 at 05:00PM

[dailyeconomicsnet]

Real Life Emotional & Cognitive Biases simplified for a Retail Investor

Emotional and Cognitive Bias:

Let us begin with a story of a small retail stock trader and insurance broker, Mr. Shanti, aged 48 years. One day when the Indian stock markets opened at 9:15 a.m, he was perplexed to see that one of his small-cap infrastructure stock which a day before was at INR 120, had dropped by 18% within half an hour of trading. He had invested INR 29,160 in this stock in June 2019; when he saw an article about the stock in the daily newspaper and also saw a few analysts talking about the stock in the business news channels on the same day. He then did his basic research on the stock and when satisfied, placed an order for buying the stock for INR 108.

Now, on the day when the stock fell more than 18% during the day and closed down 15%; there was news that 27% of the company’s shares were pledged by the promoter. He however was quite confident that this is not a major problem and fundamentals are intact. The next day the stock again fell by 10% and over the week the stock halved in value. Mr. Shanti thought that this phase would pass and that as soon as the stock recovered or bounced back to his original cost of INR 108, he would exit the company. This story ends with the same climax that many retail investors faced while investing in small or mid-cap companies (cap stands for market capitalization; meaning the total market value of the company). As you would have guessed, the climax was that the stock in 6 months went to INR 10 (as during those six months it came out that the promoters were fraudulent). Our Mr. Shanti still has 270 stocks lying in his DP worth only INR 2,700. This is quite a common story for a small investor. Did Mr. Shanti act rationally or was driven by some biases? We shall answer these questions in a while you shall be able to answer them after reading this article. First, let’s learn about some emotional and cognitive biases that affect our decision making consciously or subconsciously. Here, let me pause and share with you that I am not an expert in this field and am just a novice learner of behavioral finance; I also would want to confess that even I have fallen prey (and still am subject) to several of these emotional and cognitive biases.

List of ten emotional & cognitive biases:

·        Loss Aversion and Disposition Effect – In this bias, we have a stronger tendency to avoid losses relative to realizing gains. We react more negatively to a given amount of loss than positively to the same amount of profit. Disposition effect leads to the holding of investments that are at losses for a much longer period and selling profit-making investments too quickly. This is exactly what a rational investor should avoid doing. 

·         Self-Control bias – This is one of the emotional and cognitive biases when we are tempted to give up our self-control or self-discipline for some short-term pleasure. For example – a retail investor who is not well informed is letting go of self-discipline while speculating in penny stocks or small caps. This we do to satisfy our desire to become rich from stock markets overnight; which leads to letting go of risk aversion (which is the tendency to choose capital preservation over higher returns)

·         Overconfidence bias – By nature, the majority of human beings are confident in their abilities. I believe we should be confident. But the problem begins when we become overconfident; especially in-stock selection or understanding the market. Overconfidence bias leads us to overestimate our knowledge of the stock and our ability to understand its business fundamentals and consequently evaluate the impact of good or adverse news on the stock price.

·        self-attribution bias – For example, you suggested an IT stock to Mr. Sheetal and an NBFC stock to Mr. Vimal; IT stock appreciated significantly and the NBFC stock corrected (fell) significantly. When you meet Sheetal; you say “see my analysis; what a superb return the stock gave” but when you meet Mr. Vimal you say “the market corrected that’s why the stock fell”. This is a self-attribution bias.

·        Availability Bias – We tend to focus on information that is easily available to us. If we get a stock idea easily; we start believing in the viability of that idea. For example – acting immediately on investment advice that you read early morning in the newspaper is availability bias.  

·        Status quo bias – It is the tendency to avoid taking any action. Once an action is taken, we prefer the remaining status quo than changing our actions. Because of status quo bias, we tend to hold on to our stocks even though they are proved to be incorrect decisions.

·        Endowment bias – It is an inclination to value an asset more when you own it or possess it relative to when you do not own or possess it. We tend to quote higher prices when we want to sell something than if we were to buy the same thing. This leads to an illusion that what we own is valued more, irrespective of its fair market price; hence we tend to hold them for a longer period than required. 

·        Regret Aversion Bias – It is a tendency to not take any decision because of the fear that what if, the decision we take turns out to be bad. Holding onto a stock for a much longer period than required; to avoid the regret caused by the chances of price rallying (increasing) after we sell is due to regret aversion.  

·        Anchoring Bias – We tend to get anchored to certain numbers or aspects while taking decisions. For example, keeping a target in mind for selling a stock or buying a stock and not acting until it reaches that price is some sort of anchoring.

·        Belief Perseverance Bias – It occurs when we ignore new information that contradicts our earlier held belief based on which we have already acted upon. Here we do not modify our belief. For example, if we have bought stock then we stress upon only the positive information and ignore or underestimate the effects of all the negative information.

By now, I guess, you would have identified which emotional and cognitive biases Mr. Shanti was acting upon in our story. Please feel free to comment on the name of the biases (amongst these 10) that you believe Mr. Shanti had.  

Remembering the name of the biases is secondary, but acknowledging that we human beings show these biases and several other emotional and cognitive biases during decision making; is the key here. Some of these we can overcome; while some of the biases are so inherent that they cannot be overcome. The ways to overcome, maybe, might cover in some other article; provided this finds your interest. The first and the most important step to overcome the biases is to acknowledge that we are biased beings.     

One quote I came across while attending my certification from Duke University is quite impressive; “The human understanding, when it has once adopted an opinion, draws all things else to support and agree with it” – by English philosopher Francis Bacon. 

Let’s end this with a quiz – In each of the below cases, you are showing a bias (there can be more than one biases playing at a time). A challenge for you! If you can identify the emotional and cognitive biases, then feel free to drop a line in the comments section mentioning which ones can you identify (also a rationale would be welcome):

Case 1. You bought a Banking stock, as soon as an analyst recommended it on a business news channel?

Case 2. You want to sell one of your Utility stocks bought at INR 630 at not below its acquisition cost; it is currently trading at 450. You like the stock and feel its value should be more than your cost.

Case 3. You sold a Pharma stock that was doing pretty good; it came out with market-beating results as well? You bought it for the long term but sold within 6 months.  

Trivia: 

1.     Loss aversion bias was identified by Daniel Kahneman and Amos Tversky (1979)

2.     In 1985, Shefrin & Statman coined the Disposition effect

3.     Status quo bias was coined by Samuelson and Zeckhauser (1988)   

Sources & References: The CFA Institute, USA Refresher Reading for members “The Behavioural Biases of Individuals” and Duke University

AUTHOR:

CA Jinesh Sarat Sheth ACA, CFA

CA Jinesh Sarat Sheth, ACA, CFA holds the designation of Investment Director; presently Heading Investment & Research Team of a Highly Reputed Family Office based in Kuwait. He is also a Member of the US “CFA Institute Practice Analysis Working Body” for the year 2020. He is an enthusiastic writer having written articles for The Institute of Chartered Accountants of India (ICAI) Local & International Chapters, The Institute of Cost Accountants of India (ICMAI) Journal & Industry magazines.