Recognizing And Avoiding Confirmatory Bias

11/19/14 03:45:57 PM

by Stella Osoba, CMT

Cognitive biases are thinking errors that affect how we process information and make decisions. We are all affected by cognitive biases in our everyday decision making but what makes them so insidious is that often we are not aware that we are acting under the influence of a cognitive bias when we form opinions or make decisions. When it comes to trading, our results rely on our ability to recognize and limit the influence that these errors of judgment can cause. Here you will find a discussion of a cognitive bias known as confirmation bias and be presented with tools to recognize it and avoid acting under its influence in making trading decisions.

Security: AMZN
Position: N/A

Confirmation bias is the process of selectively seeking out information that confirms an earlier opinion or position we have taken. This particular bias is especially harmful because unless we have trained ourselves otherwise, it can be insidious and difficult to spot and correct. For instance, you've watched Amazon (AMZN) form a base between April and early June. You wait for an opportunity to enter a long trade. You watch the share break above its 50-day moving average on high volume. It trades in a range for a couple of weeks and then breaks out on high volume on July 11, 2014. The following day you enter the trade. But as the share price moves higher, it does so on declining volume. Now that you are in the trade you choose to explain away this fact as not being significant or relevant. You fail to recognize that you are doing this or why you are doing it. This is confirmation bias at work. Evidence that is not confirming your trade idea is dismissed or excused away and as you do this, you barely notice. You make excuses which sound justifiable, so you might say something like, volume is not always so accurate anymore with all the high frequency traders out there. Back to our trade. On July 24, 2014 a hanging man candlestick forms which is a warning of trouble ahead. But once again you believe in your stock so the signal does not appear nearly so significant. Then the following day the shares gap down on very high volume, wiping out all your profits. Now you are staring at a substantial loss. Something is wrong but your need to be right tells you the price will go back up. After all, price has not yet reached the lows seen in May, so you hang in there and sure enough the share gaps back up. You feel vindicated, you were right. You knew it all along. You ignore all the signals the market sends out and you continue to hold as the shares reverse back to the downside. You finally throw in the towel in October, when you can no longer bear the pain of a substantial loss.

One of the reasons for this bias is our need to self validate. Sometimes the roots of confirmatory bias is to be found in our sense of self worth, our need to prove to ourselves that we are right, or that we are good enough, or smart enough or what ever psychic injury we are overcompensating for. Sometimes when we allow our egos to get in the way, we will find ourselves selectively looking for information to prove to ourselves that our original hypothesis is correct. Look, I must be right, we tell ourselves, see and then we point to something that will confirm our opinion - maybe it is the grade given to our stock by an analyst at a brokerage house, maybe it is the positive feedback in the chat rooms, maybe it is our own analysis of indicators which confirm our opinions on the position.

Figure 1. Price Breakout. The price of Amazon, Inc. (AMZN) breaks out on high volume on July 11, 2014. This prompts you to buy but fail to notice that price is rising on declining volume. Do you continue to hold or do you sell?

Graphic provided by: StockCharts.com.

The only way to combat this bias is through honest self reflection. We need to be aware of our mental processes and listen to our thinking. Metacognition is the process of thinking about thinking and this is a skill we need to cultivate. We must learn to slow our thinking processes down and look for clues which can lead us to areas in our thinking which are fuzzy. And we must remember the following rules:

1) The market is always right. It does not know you and does not care that you are trying to make a profit.
2) Do not ignore information which conflicts with your hypothesis. It could be an early warning that something is wrong.
3) If the trade is not doing what it should, get out. Remember rule one.
4) Always have a written plan for each trade and set trading perimeters before you enter the trade.
5) It is okay to be wrong as long as you recognize it early and get out fast.

Stella Osoba, CMT

Stella Osoba is a trader and financial writer. She is a frequent contributor to "Technical Analysis of Stocks and Commodities" magazine and "Traders.com Advantage" as well as other financial publications.