Judgment Errors to Avoid While Stock Trading

by Susan Porter
(Los Angeles)

There has been a long standing debate in the world of psychology asking us how much of a person is affected by their natural genetic predisposition versus how much of that person is molded by the environment they grow up in; Nature versus Nurture. When you enter the arena of stock trading you often deal with some of the same issues when discovering how much of the trades you enter are affected by the natural rational choices of traders versus the market dynamics the traders come in contact with. Majority of the time you can expect traders and markets to act rationally, but every so often you will come across anomalies that seem to go against the grain of rationality.

If you want to profit while stock trading then it’s important to spend some time becoming aware of these anomalies and learn how to defend against them before you find yourself in similar situations. Preparation through awareness is over half the battle, and if you can prepare now to be ready you’re your own errors in judgment then you can also be at a competitive advantage to traders who lack the awareness.

Hindsight Bias

There is a well recorded error in judgment involving trends that traders should watch out for. If you have ever looked at a graph of your favorite stock and see that it increased you’ll often believe, without being conscious of it, that you knew the situation in the stock price would unfold the way that it did. Unfortunately, stock prices are terribly difficult to predict, and spotting a chart that is a linearly positive progression and believing, solely based on the previous history of the chart, that the stock will continue that way, then you are suffering from hind sight bias and aren’t actually basing your judgment on anything solid. This leaves you open for high levels of risk and the possibility of losing your investment if you don’t justify the chart movement with real life business activity.

A way to avoid this is to study probability more closely and realize that knowing last week’s stock prices doesn’t guarantee you any sort of future returns. It would be very similar to believing you could predict the outcome of your state’s lottery by knowing last week’s lottery numbers – Foolish at best.

Gambler’s Fallacy

Similar to hindsight bias, the Gambler’s Fallacy is also an error in understanding probability. If you were to flip a coin 100 times, and you got 10 heads in a row, most people would believe that the chances of there being a tails on the 11th flip will have increased and are therefore highly likely. Of course, this is a false assumption and has to do with a misunderstanding of the two types of probabilities: Dependent and independent. A series of coin flips is considered independent because each flip is independent of the other, that is, you could flip a coin 99 times, have it be heads, and the odds of it being either heads or tails on the 100th are still 50/50.

The error that people are making with the Gambler’s Fallacy is to treat the coin flipping situation as a dependent variable. If you had a container with 50 white tokens and 50 black tokens and you had to reach in and pull a token out and record what color it is – If the first 10 tokens you pulled out were white, then your probability of the next one being a black token has definitely increased.

Becoming a stock trading expert requires sound judgment, and sound judgment requires awareness of how you and other stock traders think. If you want to increase your odds of success in investing then it is in your best interest to learn as much as you can about the common errors in judgment we make when dealing with money and how best to avoid them.

Susan Porter is a financial expert whose interests have led her to study financial topics from stock trading to decision making under uncertainty. Get more tips and advice on the blog Stock Trading.Net.