What psychological challenges do traders face in forex? This article will cover these by explaining various biases.
Psychological challenges plague just about every financial decision made by people. A financially successful person is one with a mastery of their emotions for making and keeping money.
Interestingly, many of the issues ordinary folk face in everyday life regarding money matters also apply to the sphere of trading currencies. The literature often suggests the significance of psychology, where the majority tend to focus too much on the technical side.
While the latter is crucially essential, trading is equally an emotional game. This article will cover the five major psychological challenges traders face through particular biases, from how investors believe in having a ‘hot hand’ to their perceptions of result events.
#1: Hindsight bias
One premise about any financial market is past performance is never a guarantee of future events. One of the most challenging things with trading is dealing with past data to predict future outcomes.
Traders look for repeatable patterns in the belief they will play out in the same way at a later time. In reality, the result of a position is entirely random. It’s easy to make an assumption about a specific setup by believing it would have been profitable had we taken it.
Traders see things that have happened as more likely to occur again before placing a trade. Some of the language someone may use here could be, “If I had taken that position, I would have made money,” or “I knew I shouldn’t have taken that trade; I could have avoided that loss.”
In this scenario, everything is based on hindsight. Traders need to understand we take a risk on every position with no control over what will happen afterward, meaning a loss is always likely. At the same time, without executing, there is no gain nor loss.
Having hindsight bias suggests someone with some form of analysis paralysis seeking explanations for why something happened the way it did. In short, trading is all about probabilities rather than certainties.
#2: Hot hand fallacy
The idea of the ‘hot hand fallacy’ comes from American basketball, where the player is deemed to have a higher chance of scoring after scoring several baskets consecutively without a miss.
This behavioral influence primarily occurs when a trader is on a so-called winning streak. They will start to believe the following position will not lose, often resulting in substantial risk way above their previous.
The main cause of this fallacy boils down to how traders miscalculate the odd independence of each trade they execute in the markets. Ultimately, closing a position will mathematically result in either some equity increase or equity drawdown.
Regardless of the number of orders taken, the distribution of losers and winners does not follow a pattern set in stone but is random. The simplest way to overcome the hot hand fallacy is maintaining a neutral mindset.
Overconfidence creeps in when someone starts winning a few trades consecutively. The outcome of every trade is entirely independent of the previous one and should be assessed on its own merit.
#3: Recency bias
Recency bias is linked to the hot hand fallacy, but it also deals with losing streaks. Interestingly, it does spill into hindsight bias as it seeks to explain how traders perceive past events.
More specifically, however, recency bias is simply the tendency for someone to focus too much on recent events and frame those as their likely trajectory in the future. Where the hot hand fallacy sees the trader believing their winning streak will continue, recency bias is familiar with losing streaks.
We have just explored the significance of treating every position as just another position. Another way to overcome recency bias is having a long-term outlook on performance. It is common for traders to become insecure over their short-term results without accounting for the bigger picture.
Placing too much significance on one trade can make even the most experienced lack confidence in their abilities. Trading is a lifetime journey. The outcome of one position doesn’t matter nearly as much as the ability for a trader to continually execute according to their trading plan until they experience the much-desired winners.
#4: Sunk cost fallacy
The sunk cost fallacy describes the inclination for people to stick out with an endeavor they’ve already invested some effort and funds in, despite it not producing any significant gains.
Of all the situations sunk cost fallacy can occur, it happens most often in how traders may add onto an already large position without a stop loss. In such a scenario, the trader will presume the market is due to move in their favor, allowing them the potential to exit with a smaller loss, no loss, or even a profit.
This fallacy all boils down to how someone can frame a particular trading opportunity as a sure thing because it takes some effort into the analysis and, of course, money.
Aside from the significance of always defining one’s invalidation point, traders should never believe a position won’t fail.
#5: Bandwagon effect
A bandwagon effect is a form of social proof or herd mentality prominent in all investment activities where traders copy others. In this modern digital social media age, it’s easy for investors to be influenced by all types of financial media, especially when they lack confidence and experience.
This effect is more pertinent in the online world and less so in human interaction. It typically manifests in the form of a so-called expert providing a ‘sure-fire trade’ based on their analysis.
In other cases, it’s any situation where a trader has to confirm their trading ideas with a group or individual they see as more well-informed than themselves. It’s understandable people naturally gravitate towards a social construct before making a trading decision.
However, trading forex is a very solitary endeavor, and a profitable trader makes their own decision with no public influence and holds full accountability for anything happening afterward.
Riding away the bandwagon comes down to traders gaining the proper knowledge and experience and consistently asserting the right decision.
This article represents the bulk of the psychological challenges the vast majority face in forex. Many experts agree trading is actually a process of self-discovery. The most successful traders are directors of themselves and learned to deal with their impulses and temptations.
Dr. Alexander Elder said it best when he described the ‘three Ms’: method, money, and mind, the latter of which is psychology. Even the most gifted traders in the world will fail in the markets without a mastery of their minds.