In online trading, it’s best to always be prepared, to expect the unexpected. Confirmation bias can sabotage a trader’s strategy quickly because they fail to map out all possible trade outcomes correctly and lack a contingency plan. Confirmation bias is a silent killer of investment success because it gets the investor or trader away from objective thinking and has them trading in the realm of emotions where overconfidence, fear, or lack of proper research due to laziness can take over.
Say an investor is gung-ho about trading stock with a company, so much so that they don’t look at any negative information or reports about the stock because they feel confident about it performing well. This confirmation bias can lead the traders to make a poor investment decision and it could look like not having a hedge in place, not setting up a stop-loss order, or dedicating too much capital to that one stock.
Check out this guide on confirmation bias to help you recognize and overcome confirmation bias in your trading strategies. It’s possible to get away from this silent killer and adopt healthy trading practices, but it comes with some practice and discipline.
What Is Confirmation Bias?
To give you a good idea of what confirmation bias is and how it works, we’ve outlined the official definition, a brief background of how confirmation bias works in the human brain, and a real-world example of how confirmation bias could play out for a trader to their detriment. If you feel you are falling into the trap of confirmation bias more often than not, keep reading because we will provide some solutions further along in the guide for dealing with this trading blind spot.
Definition
Confirmation bias is the tendency to interpret new evidence as confirmation of one’s existing theories. When it comes to trading and investing, confirmation bias is the tendency for traders to seek, interpret, and remember market data or information that supports pre-existing beliefs.
Brief Psychology Background
How does confirmation bias work in the brain, and why does it make traders feel “safe?” In the brain of the trader, confirmation bias is supported when traders actively seek out or prioritize information that aligns with their trading goals or what they hope will work for their options portfolio. They will ignore or downplay evidence that goes against their fundamental beliefs or theories on trading. Within the brain, the process of confirmation bias alters how the brain interprets incoming information. In this case, it’s done based on pre-existing judgments.
While some traders might use this mental shortcut and achieve successful results quickly due to how much shorter it is than researching both sides of the possible outcome, there are instances where they don’t see the entire picture and come to an inaccurate conclusion.
Real-Life Example
The best way to ultimately explain confirmation bias is to outline an example of something that could hypothetically happen to a trader. The false sense of certainty that comes from confirmation bias all begins when an investor is so sure something may or may not happen that it blinds them to any kind of news or updates that might point to the alternative.
A good example is an investor or trader being confident that a new tech company is going to perform well. They might get this idea from other traders who are hyping up the company or from some basic research into the stock price, which is indicating that stock has been climbing higher and higher. This could cause the trader to only seek out information and updates that reinforce their belief that this new tech company is going to continue to grow and perform well.
The trader might completely ignore any kind of warning signs that indicate potential problems. They’re so focused on the idea of the company experiencing success that they might regard negative news or reports as completely invalid. Either that, or they might not even look into any contrary news. This creates a trading blind spot where the stock could perform poorly, and the trader takes a loss because they didn’t have a contingency plan in place to deal with the price drop.
How Confirmation Bias Impacts Investment Strategies
Confirmation bias can hurt trading and investment decisions, including poor decision-making, the failure to correctly manage risk, and missed opportunities. Confirmation bias can get a trader away from rational, objective thinking which leads to some negative outcomes. When traders get too fixated on a handful of companies on investments, they can miss out on trading basics like diversification, pivoting to different strategies to adapt to market conditions, and falling victim to all sorts of risks.
Poor Decision-Making
One of the most common manifestations of confirmation bias in trading is poor decisions made where traders ignore contradicting evidence. For instance, a trader suffering from confirmation bias might overlook negative earnings reports because they might contradict the outcome they are hoping that their trading strategy will deliver. Even though the desired outcome could technically happen even with this oversight, there’s still a chance that the trader could be making poor decisions because they aren’t taking all the relevant information and factors into account.
With confirmation bias, there’s an overemphasis on “cherry-picked” data supporting a trade or investment. This refers to the practice of selectively choosing data that supports the trader’s beliefs. The cherry-picked evidence that’s found in a lot of confirmation bias tends to be ambiguous or could be interpreted differently.
Risk Management Failures
Another negative effect that confirmation bias can have on one’s trading decisions is the losses that someone can incur when sticking with losing trades longer than necessary. This can stem from something like loss aversion, where traders fear losing any of their capital, and they’re waiting for the investment to turn around. However, holding onto a trade for too long can also be the result of a trader with conformational bias looking at only the data they want to see, and they truly believe the stock will perform well again before the expiration date.
Another risk management failure could be a trader underestimating market volatility due to biased research. This trader might have high hopes for the market because they want to remain optimistic and are afraid of seeing a market downturn because they have loss aversion. They might look for evidence that the market is going to go up and ignore other data that might suggest a market downturn. They could be right or wrong, even with their conformational bias, but they could lose out on some investments if they fail to do the proper risk management in preparation for either outcome.
Missed Opportunities
Traders can have bad confirmation bias to the point where they avoid promising investments that might conflict with existing beliefs. We equate this to a horse having blinders on where they cannot see any other direction forward. Investors can be so fixated on their current strategy that they might miss out on opportunities in new, innovative companies or emerging sectors that show a promising future.
Conformational bias can narrow market exploration because the trader or investor is too focused on their existing goals and shutting out any contrary viewpoints on making a profit. There are significant returns to be made in multiple areas of the market, and conformational bias can keep some traders confined to a small corner of a market of possibilities.
Why Are Investors Susceptible to Confirmation Bias?
It’s no wonder that many traders and investors fall victim to confirmation bias. Even in just regular life, it can be easy to call into thinking and operating in a way where our beliefs and worldview are reinforced. You can become overconfident at times in your abilities. Following ideas or beliefs that are socially acceptable is much easier than going against the flow of groupthink or the hivemind on any given subject.
Check out three ways that investors become susceptible to confirmation bias when making trade decisions:
- Emotional Comfort: Sticking with what you know and believe is the comfortable thing to do. It can be difficult to have your assumptions and beliefs challenged. Some differing viewpoints can trigger discomfort in a trader because it could indicate that they must take contradictory ideas in their minds and reconcile them. Confirmation bias reduces cognitive dissonance because looking only for evidence that confirms one’s current stance minimizes internal conflict and maintains psychological consistency.
- Overconfidence: Investors with considerable experience tend to fall into this second category. After years of trading, these individuals can begin believing more in their ability to predict market movements than in analyzing all the available data to get the big picture. This overconfidence can make investors look for some quick evidence to back up their hunch on where the market is going and look no further than that.
- Social Reinforcement: Following groupthink or social media narratives is another common way for traders to fall into confirmation bias. It can become easy to trade where the public momentum is and overlook profitable contrarian market outlooks. Some traders might be making their decisions based on what their peers are doing and using this social reinforcement as the basis for their decision-making.
Identifying Confirmation Bias in Your Trading
There are times when it can be difficult to identify confirmation bias in your trading decisions because it isn’t always so apparent. We’ve put together a list of red flags to watch out for that might indicate that confirmation bias is playing a significant role in your decision-making.
Red Flags to Watch Out For
If you’re wondering how to spot confirmation bias in your trading practices, we’ve included the following red flags to watch for.
- Avoiding Counterarguments or Alternative Viewpoints – You make a concerted effort to not seek out alternative viewpoints and counterarguments that go against your current beliefs.
- Seeking Only Positive Reviews – Another sign of confirmation bias is when you only look at positive reviews of specific stocks or strategies. It’s key to know the downsides of these kinds of investments or techniques to know what kind of risk you could be getting into. Otherwise, you could be going into a trade or using a trade strategy thinking that there are only benefits to be had. Some risks come with every kind of options trade or strategy you employ, and that’s a fact.
- Consistently Disregarding Expert Advice That Conflicts with Personal Beliefs – Just because you disagree with another viewpoint doesn’t mean that the person presenting it isn’t wrong or right 100% of the time. Disregarding expert advice outright from someone who doesn’t share your thoughts and assumptions is a surefire way to miss out on opportunities or continue to have a trading blind spot.
Self-Assessment Questions
If you feel like you could be someone who’s letting confirmation bias play a role in your trading activities, but you aren’t quite sure, we’ve included a couple of self-assessment questions that should give you an answer fairly quickly.
- Are my sources balanced?
- Am I making decisions based on facts or feelings?
When traders aren’t getting information on their trades which explore each outcome in depth, they fail to come up with a contingency plan if their market outlook or predictions were incorrect. It’s key for traders to use techniques like hedging, stop-loss orders, using conservative position sizes, and diversifying their portfolios to deal with potential risks. Good options traders should take the posture that anything could happen and that they best be prepared to deal with unfavorable market movements.
Strategies to Overcome Confirmation Bias
Anyone who is ready to begin overcoming their confirmation bias might want to read this next section of the guide, where we go over some strategies in building a balanced research process. Readers can also learn about implementing structured decision-making and using feedback loops to their advantage.
Build a Balanced Research Process
– Diversify Your Information Sources: Get the information and data to research your traders from multiple sources, including those that might not support your current beliefs and assumptions about the market. The only way you can successfully maneuver market swings is by having a full awareness of the top potential rewards and risks associated with each trade. A heavy focus on one or the other will create a blind spot, and you will be blindsided and with no strategy in place to deal with the unexpected outcome.
– Actively Seek Out Opposing Viewpoints: Look for opposing viewpoints. They might be your source for finding out where you can improve your current strategy and where your trading blindspots might be. Seeing things from a different angle or point of view can expose you to ideas that you could have been missing out on. The more techniques and approaches you can learn in trading, the more dynamic your sessions could be.
– Use Data-Driven Tools: To balance your research process, use tools like charts and market indicators to gather data and do so in an objective way. Market indicators can be used to interpret financial data and predict stock market movements. It’s done using moving average, on-balance volume, and relative strength index. Trading charts are also helpful and show the price and volume of the asset over time.
Implement Structured Decision-Making
The next important step you can take to continue building your balanced research process is to create a trading plan with clear entry and exit criteria. Because you’ve researched the trade from multiple angles and included a variety of voices in your sources, you’ll have a firm idea of the potential profit and risk associated with each trade (or something close to it). Plus, with the knowledge of where the market currently is, you can now make a structured decision where you pinpoint the most desirable price to enter the trade as well as a plan for exiting the position when the time comes.
Another important element of structure decision-making is reviewing and adjusting strategies based on unbiased metrics. It’s key to analyze objective, factual data that isn’t influenced by your personal biases or opinions. This includes:
– Collecting data consistently from reliable sources.
– Analyzing data objectively by focusing on patterns and insights.
– Determine the key indicators that reflect the success of your strategy.
– Understand what the data shows about the effectiveness of your strategy (correctly interpreting the results).
Use Feedback Loops
Regularly review past trades to identify biased patterns using feedback loops. This continual process analyzes their prior trades, learns from the results, and makes tweaks and improvements to their future trading strategies. Ideally, the feedback loop is neverending, where traders continually learn and improve their approach.
In addition to a trader going through their own learning process, they can also learn from other traders like them or those with more experience. It could be advantageous to work with a mentor or join trading communities for accountability.
Tools and Techniques to Combat Confirmation Bias
It’s one thing to begin practicing trading routines and patterns that get you away from confirmation bias, but it’s another to combat the reflex to resort to confirmation bias in the future. Check out these tools and techniques for fighting against the urge to fall back on confirmation bias in your trading routine.
- AI and Algorithmic Tools: There are helpful tools out there for traders who desire objective analysis. In particular, algorithmic trading tools help investors execute traders in financial markets with computer programs based on pre-defined rules. This can keep investors away from subjective trade decisions where confirmation bias can slip in.
- Apps or Platforms with Diverse Market Insights: Find the data analysis you need to identify trends and form actionable insights. Many of the best trading platforms come with top-notch technical and fundamental analysis. This allows traders and investors to look at objective information like historical price and volume patterns as well as company financials and economic indicators that keep the temptation to slip into confirmation bias at bay.
- Journaling: Record trades and reflect on decision-making processes to keep in an objective frame of mind. It’s never easier for confirmation bias to sneak into your decision-making than not recording what has worked or not worked for you in your trading sessions. Keep a good journal to make trading a continual learning process of getting better and taking all potential outcomes into account with each trade.
Don’t Let Confirmation Bias Creep Into Your Decision Making
Confirmation bias is unhealthy in online trading because it draws the trader out of an objective, rational frame of mind. It’s key for traders to maintain objectivity if they want to deal with the fast-paced environment of trading and to realize a profit amid shifting market conditions. A good indication that you might be suffering from confirmation bias is if you refuse to look at contrary positions from your current strategy, thoughts, or assumptions.
Combatting confirmation bias can be as simple as having set entry and exit points for each of your traders, using modest position sizes, having take-profit or stop-loss parameters for each position, and having diverse investments. The more good practices you get into with trading, the more you can get away from confirmation bias. Overcoming this challenge is a continual learning process, so don’t be too hard on yourself if you’re struggling. So many traders have been there and overcome it with time.
Evaluate your current strategies for bias and explore additional resources on OptionsTrading.org.
