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The Emotional Purgatory Of Cognitive Biases – Part 1
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The Emotional Purgatory Of Cognitive Biases – Part 1

by The MoleSeptember 21, 2016

Today and tomorrow we are being treated to a veritable triple whammy of central banker sponsored market perturbations. For an early sample of what to expect over the next two sessions look no further than the spasmodic whipsaw the USD/JPY just painted earlier this morning.

2016-09-21_yen_dip_and_bounce

What you are looking at is price action fueled by pure human emotions. More specifically those spikes represent a mixture of fear and greed. Large opposing candles are usually produced by an attempt to anticipate and respond to already unfolding events. In this case market participants scrambled to adjust to more exotic BOJ policy changes in an attempt to be among the first to take advantage, or at minimum not to be left holding the bag. In my mind this is a complete waste of time unless you have direct access to considerable liquidity and are thus managing funds that exceed tens of millions. For everyone else the best policy is to simply stay out of the water and let the sharks gorge themselves until they’re fat and happy.

Since we’re talking trading psychology and the emotional purgatory most of us have to endure on an ongoing basis I thought it a great opportunity to launch a little mini series I call the ’emotional purgatory of cognitive biases’. To that end I will once again stand on the shoulders of giants, which means copying the most brilliant excerpts of known authors prolific in this area. One book you may enjoy is ‘The Art of Thinking Clearly’ by Rolf Dobelli. It’s rather comprehensive and there is a free summary available by Endika Aboitiz, Jr. which I will be heavily plagiarizing.

What I’ll be covering in this mini series will not always be directly related to trading. However I do believe that the untrained human mind represents a bona fide smörgåsbord of conflicting habits, beliefs, and opinions; some of it being personal and much of it owing to cultural or regional proclivities. And as such the act of self reflection or recognition in unrelated areas may yield to a more objective approach in others.

01. Survivorship Bias – Why you should visit cemeteries

Triumph is more visible than failure. You systematically overestimate your chances of succeeding. Guard against it – visit the graves of once – promising projects, investments, and careers. It’s a sad walk that clears your mind.

02. The Swimmer’s Body Illusion – Does Harvard make you smarter?

Professional swimmers don’t have perfect bodies because they train extensively. They are good swimmers because of their physiques. How their bodies are designed is a factor for selection and not a result of their activities. Female bodies advertise cosmetics and, thus, too many female consumers believe that these products make you beautiful. It is beautiful women that are candidates for cosmetic advertising. So before you take the plunge, look in the mirror and be honest about what you see.

03. Clustering Illusion – Why you see shapes in the clouds

The human brain seeks patterns and rules. It takes it a step further – if it finds no familiar patterns, it simply invents one. When it comes to pattern recognition, we are oversensitive. Regain your skepticism. If you think you have discovered a pattern, first consider it pure chance. If you see Jesus in your pancakes ask yourself, “If he really wants to reveal himself, why doesn’t he do it on CNN?”

04. Social Proof – If 50 million people say something foolish, is it still foolish?

In the middle of a concert, someone claps – suddenly the whole room joins you. Social proof is the evil behind bubbles and the stock market panic. A product is not better because is sells more.

05. Sunk Cost Fallacy – Why you should forget the past

Having paid for a movie is not a reason to stay through a bad one. “We have invested so much money in it. If we stop now it will all have been for nothing.”–the investment as a reason to carry on. The more you invest, the greater the sunk cost. This irrational behavior is driven by a need for consistency. Consistency signifies credibility. Rational decision-making requires you forget about costs incurred to date, no matter how much you have invested. Only your assessment of the future costs and benefits matter.

06. Reciprocity – Don’t accept free drinks

NGOs and philanthropist give, and then take. People have extreme difficulty being in another’s debt.
Reciprocity – a very useful survival strategy; a form of risk management. Without it, humanity and countless species of animals would be long extinct. The ugly side of reciprocity – revenge and retaliation. How many dinner parties have been endured in the name of reciprocity?

07. Confirmation Bias Part One – Beware of the special case

Facts do not exist because they are ignored. What the human being is best at is interpreting all new information so that their prior conclusions remain intact.

08. Confirmation Bias Part Two – Murder your darlings

Whether you go through life believing that “people are inherently good,” or “people are inherently bad,” you will and daily proof to support your case. Religious and philosophical beliefs are an excellent breeding ground for the confirmation bias. The Internet is particularly fertile ground for the confirmation bias. To stay informed, we browse news sites and blogs, forgetting that our favored pages mirror our existing values. Write down your beliefs – look for disconfirming evidence. Axing beliefs that feel like old friends is hard work but imperative.

09. Authority Bias – Don’t bow to authority

The Bible – you disobey a great authority, you get ejected from paradise. Authorities pose two main problems to clear thinking. Their track records are sobering – no one predicted the timing of the 2008 financial crisis, let alone how it would play out. Airlines have learned the dangers of the authority bias. Especially at risk – organizations with domineering heads. Lesser opinions are kept to themselves. When you are about to decide, think of what authority figure might be exerting an influence on your reasoning. When you encounter authority in the flesh – challenge.

10. Contrast Effect – Leave your supermodel friends at home

We judge something beautiful, expensive, or large if we have something ugly, cheap, or small in front of us. We have difficulty with absolute judgments. We don’t notice small gradual changes.

11. Availability Bias – Why we prefer a wrong map to none at all

We create a picture of the world using examples that come most easily to us. Things don’t happen more frequently because we conceive of them more easily. We travel through life with an incorrect risk map. We overestimate the risk of being victims of a plane crash than from dying from diabetes. We attach more risk to the loud and spectacular and less to the silent. “The Internet is particularly fertile ground for the confirmation bias. To stay informed, we browse news sites and blogs, forgetting that our favored pages mirror our existing values.”

We think dramatically and not quantitatively. Doctors and consultants practice what they know. We don’t have another solution, so we carry on with the incorrect tool. We prefer wrong information to no information. Spend time with people who are different from you – people whose experiences and expertise and outlook are different from yours.

12. The It’ll-Get-Worse-Before-It-Gets-Better Fallacy

Why “no pain, no gain” should set alarm bells ringing. If someone says that alarms should ring. Situations exist where things first dip, then improve. Not a religious zealot who believes that before we experience heaven on earth, the world must be destroyed.

13. Story Bias – Even true stories are fairy tales

Life is a muddle. We like to knit a jumble of details into a neat story. We want our lives to form a pattern that can easily be followed. We try on stories like we try on clothes. Stories attract us; abstract details repel us. Reality is distorted.

Take them apart – what are they trying to hide? Events that look connected today were not at the time. Events are not linear. Who is the sender? What are his intentions? What did he hide under the rug? What omitted elements may have been relevant? The real issues with stories – they give us a false sense of understanding.

14. Hindsight Bias – Why you should keep a diary

“I told you so.” Makes us think we are better predictors than we really are, causing us to be arrogant about our knowledge and consequently take too much risk. Keep a journal. Write down your predictions – compare. Read history – the diaries, oral histories and historical documents, not the compacted theories of textbooks. If you can’t live without news, read media from 10 years ago. You will see how unpredictable the world is.

15. Overconfidence effect – Why you systematically overestimate your knowledge and abilities

Experts suffer more from overconfidence than lay people. 84% of Frenchmen estimate they are above average lovers. 93% of US students estimated they are above average drivers. The return on investment in the restaurant business lies chronically below zero. They keep opening. Hardly any projects exist that are completed on-time and below budget. Those with direct interests have an incentive to underestimate the costs. Consultants, contractors, and suppliers seek follow-up orders. Even pessimists overestimate themselves – just less extremely. Challenge predictions.

16. Chauffeur Knowledge – Don’t take news anchors seriously

Two kinds of knowledge: Real knowledge – from time and effort dedicated to understand it. Chauffeur knowledge – from having learned to put on a show. Hard to tell the difference. From anchors, easy. From journalists, hard. Circle of competence – what lies within, you understand intuitively. What lies outside, we comprehend only partially.

Stick to your circle of competence. It does not matter how large the circle is so long as you know where the perimeter is. If you play where others have the aptitude and you don’t – you will lose. Be on the look out for chauffeur knowledge. How? True experts know the limits of what they know and what they do not know. They unapologetically keep quiet or say, “I don’t know.”

17. Illusion of Control – You control less than you think

People choose numbers for a lottery thinking it makes a difference. People throw dice harder thinking it makes a difference for a high number. The idea that people can influence their destiny, even by a fraction, encourages prisoners not to give up hope. Door open and door close in an elevator – many are not even connected. Fake temperature dials in offices – reduced energy bills. Overnight interest rates – the market reacts frenetically. Focus on what is important to you – and the rest, que sera, sera.

18. Incentive Super Response Tendency – Never pay our lawyer by the hour

To control rat infestation, French colonial rulers in Hanoi passed a law – for every dead rat, the catcher would receive a reward. Many rats were destroyed but many were bred for this purpose. Managers being paid for hitting targets – targets are lowered. People respond to incentives by doing what is in their best interest. Behavior changes quickly when incentives come to play. Good incentives comprise both intent and reward. They need not be monetary. Crusades – incentive – if you come back alive, you could keep the spoils of war. If you died you went to the afterlife as a martyr — a win- win.

19. Regression to Mean – The dubious effect of doctors, consultants, and psychotherapists

Back pains, record period of weather, bad- performing stock – they go back to the mean by themselves. Most successful stocks for the past three years will not be the most successful, or unlikely to be, for the coming three years. Look out for the regression to the mean error.

20. Outcome Bias – Never judge a decision by its outcome

We tend to evaluate decisions based on their results, rather than the decision process. The Pearl Harbor attack. From today’s perspective, there was plenty of evidence that an attack was imminent. Only in retrospect do the signals become clear. In 1941 there was a plethora of contradictory signals. To assess the quality of the decision, we must use the information available at the time.

Never judge a decision purely by its result especially when randomness and external factors play a role. A bad result does not automatically indicate a bad decision, or vice versa. Were your reasons rational and understandable? If so, stick to the method even if you did not strike it lucky the last time.

21. Paradox of Choice – Less is more

We are bombarded with choice. Abundance makes you giddy, but there is a limit. When it is exceeded, a surfeit of choices destroys the quality of life. A large selection may lead to inner paralysis. A broader decision leads to poorer decisions. How can you be sure you are making the right choice? You cannot.
Think carefully, write down the criteria, and stick to them rigidly. You can never make a perfect decision – learn to love a good choice. Only the best will do? Good enough as the new optimum?

22. Liking Bias – You like me, you really, really like me

There is nothing more effective in selling anything than getting the customer to believe, really believe, that you like him and care about him. The more we like someone, the more inclined we are to buy from or help that person. What does likable even mean? We see people as pleasant if they are outwardly attractive, if they are similar to us, and if they like us. Compliments work. Politicians are maestros of the liking bias.

23. Endowment Effect – Do not cling to things

We consider things more valuable the moment we own them. If we are selling something, we charge more for it than we ourselves are willing to spend to buy it. In real estate – the endowment effect is palpable – an emotional attachment. We are better at collecting than at casting out. Don’t cling to things – consider your property something that the universe has bestowed on you temporarily!

24. Coincidence – The inevitability of unlikely events

Improbable coincidence is exactly that – rare but possible events. “Never judge a decision purely by its result especially when randomness and external factors play a role. A bad result does not automatically indicate a bad decision or vice versa.” It is not surprising when they finally happen. What would be more surprising is if they never came to be.

25. Groupthink – The calamity of conformity

No one wants to be the naysayer that destroys team unity. Expressing reservations could mean exclusion from the team. Groupthink – where a group of smart people make reckless decisions because everyone aligns their opinion with the supposed consensus. If you find yourself in a tight unanimous group, you must speak your mind, even if your team does not like it – even if you risk expulsion from the warm nest. If you lead a group, appoint someone as a devil’s advocate. She may not be the most popular, but she might be the most important.


About The Author
The Mole
Mole created Evil Speculator amidst the chaos of the financial crisis in early August of 2008. His vision for Evil Speculator is a refuge of reason, hands-on trading knowledge, and inspiration for traders of all ages and stripes. You can follow him and his nefarious schemes at various social media waterholes below.
  • Mark Shinnick

    Rules for living with the reality of life ….wish all this were taught in schools.

  • http://gerb-reloaded.blogspot.com/ Gold_Gerb

    I visited the cemetery two weeks ago. Sobering.
    try not to spend too much time in front of the screen with blinking candles.
    Time…is precious.

    I’d agree with the first ten. must save this off, and contemplate later.
    25? .. too many for my ADD, look! a bird.

    Great Post.

  • http://gerb-reloaded.blogspot.com/ Gold_Gerb

    btw, QQQ’s are strong.

    [BPCOMPQ] – neutral in my lens. and a good reason I didn’t push the INTC short the other day.

    http://stockcharts.com/h-sc/ui?s=%24BPCOMPQ&p=D&yr=0&mn=6&dy=0&id=p47918237544

  • Mark Shinnick

    Miners and PM move today relative to $ is suspicious and still not supportive for PM in my lens, so still looking to short miners.

  • kudra

    Great post. Understanding the above biases and being able to see them in yourself is powerful.

  • http://gerb-reloaded.blogspot.com/ Gold_Gerb

    SLV which often dances with miners, has found double bottom support IMHO,
    but yeah – have your lines in the sand.

    https://uploads.disquscdn.com/images/9130b9df8660af9c7d3890b8545e9132abdfff751c8ae0001ca289d846ffc095.png

  • ridingwaves
  • kudra

    closed 2/3 of the TZA. scalp.

  • Jay Thomas

    A so-called expert wrote this, huh? Some of it is rubbish. Some is poorly worded. Following all of these is not a recipe for success – it is a recipe for depression. E.g. reciprocity is a good thing; just recognize it for what it is. Murder your darlings is stupid; more like challenge your darlings.
    Authority – When I was in high school and college there was a fad going around, “Challenge authority.” The idea was to dig until you understand the context and the intent and the limits of what is taught. The problem was that the phrase was interpreted as “Reject authority.” You think you are going to overthrow general relativity by blowing it off and not studying? At work, I challenge plans all the time. Occasionally we change course; usually I end up understanding the situation better. There is a balance there.
    Changing our cognitive modes will be difficult, but worth the effort… except no pain no gain is a fallacy?
    Chauffeur knowledge – there’s a word for that – crepusculation. It is latin for “I heard at the barber shop…”
    The world does not need to be destroyed before heaven on earth can be achieved. Only Gold Gerb needs to be destroyed. Mwuhahaha!

  • Billabong

    Maybe you missed the point of this web site? It’s to discuss ideas and concepts. Besides, Mole’s primary language is German not English. No one here is a top tier professional only students in learning how to survive. A little humility and subtle slams go a long way to making your point heard…

  • Billabong

    BOJ decision set it in motion and there could also be some FOMC front running going on.

  • Billabong

    BTW, good TA and seasonal analysis points on NG a few weeks ago … thanks.

  • http://gerb-reloaded.blogspot.com/ Gold_Gerb

    (I don’t know what he’s huffing, but I’ll have some too)
    Cheers!

  • Yoda

    Sunk-cost fallacy is particularly relevant.

  • Mark Shinnick

    Yes, anything can be criticized…its the thematic pearls of those essentially sound ideas that are hopefully taken as they are intended.

  • ridingwaves

    a good guess : ]
    if they raise today, a bloody week ahead….they would really throw a shock into market…Bio sector was rolling and then bam! risk off this morning

  • Mark Shinnick

    Yep…pretty damm tight lines. Entered short miners.

  • http://gerb-reloaded.blogspot.com/ Gold_Gerb
  • ridingwaves

    Old Vix methodology is a little more bearish today than the new guy in town
    VXO vs VIX

  • Tomcat

    Still coiled up in my view…

  • Mark Shinnick

    Well…I finally got my price to short miners. Very tight stops…of course.

  • BKXtoZERO

    is this intra-day only, do or die? not liking that one myself.

  • Mark Shinnick

    It has its problems but its mainly driven by my $ models….just no way I can predict what will happen to it.

  • BKXtoZERO

    96 on dollar looks to be important line, must be inflection point time.

  • Tomcat

    No Hike but Hawkish talk? Is that consistent to what you guys are expecting?

  • Mark Shinnick

    Yeah…that is my own cognitive bias based on the “line” and other model results. Can all be total delusional BS, of course :)

  • Billabong

    I’m watching bio for a shorting opportunity.

  • Billabong

    Price action will tell us all we need to know in 40-50 mins. Then it’s almost two hours of rolling waves unless they raise rates….

  • ridingwaves

    PNF chart points to 87, needs to jump that resistance and stay above 96.50 in my lens

    http://s22.postimg.org/4zonur0kh/USD_92116.jpg

  • http://evilspeculator.com Sir Mole III

    Alright, strap on your helmet and your groin cup.

  • http://evilspeculator.com Sir Mole III

    I’m sure you’re a riot at parties 😉

  • http://evilspeculator.com Sir Mole III

    Hey, I didn’t write these (as I pointed out) so he can tear it apart as much as he wants.

  • Yoda

    Ka-ching!

  • Mark Shinnick

    Caught one in the nuts there.

  • http://evilspeculator.com Sir Mole III

    Oh jeezzz – Mark – what are you doing??

  • Yoda

    gambling

  • http://evilspeculator.com Sir Mole III

    tisk tisk…

  • Mark Shinnick

    Basing miner trade upon $ model, but with a tight stop so exited. That trade still valid in my lens, but the $ is the big question here.

  • Yoda

    Did you empty the ATM yet? 😉

  • BKXtoZERO

    in little league they tell you to get down and keep your glove in front of you.

  • kudra

    Shin: GDX headed to $26 near term. $22 by EOY.

  • Mark Shinnick

    …but just maybe not before $28.

  • http://evilspeculator.com Sir Mole III

    I may make a quick run after dinner. Tomorrow is Draghi’s turn as you know.

  • http://evilspeculator.com Sir Mole III
  • Yoda
  • randomuser6789

    One I learned a few years ago is the “Similar to me” bias. We tend to think others think like we do. This leads us to think someone is stupid when in reality they have a different lens, method, time frame, strategy, set of values, etc.

    We should not be surprised to discover others are not like us. We should be thankful. There is someone to take the other side of our trades, someone to challenge our ideas to help us see more objectively.

  • Billabong

    ok…

  • BKXtoZERO

    The old, Keep stocks up and smash the VIX play. They never get tired of running that play. I got out of VIX a bit early but glad I got ooot

  • Tomcat

    New all time highs? BTFD

  • Tomcat

    Not before some resistance into the 50 maybe:
    http://schrts.co/92Ax9e

  • http://gerb-reloaded.blogspot.com/ Gold_Gerb

    My EYES!!!!

  • Mark Shinnick

    Gold bugs no doubt getting excited now.

  • http://gerb-reloaded.blogspot.com/ Gold_Gerb
  • ridingwaves

    they should….dollar moving down for a couple months to help the world…

  • http://gerb-reloaded.blogspot.com/ Gold_Gerb
  • http://gerb-reloaded.blogspot.com/ Gold_Gerb

    Not me.
    when the ratio gets above 5.18 – maybe.
    EDIT –
    [GLD:UUP]
    http://stockcharts.com/h-sc/ui?s=GLD%3AUUP&p=D&yr=0&mn=6&dy=0&id=p85872395878

  • Tomcat

    Yes Qs
    Closing Longs here…

  • ridingwaves

    what I think the real reason behind delay other than election timing is the dollar shortage battle raging across the financial landscape, $ needs to drop to fit current demand

  • Tomcat

    dollar shortage?

  • Yoda

    Can’t be unseen 😉

  • Tomcat

    Best tweet of the day: Don’t forget to thank your local Fed member for your portfolio gains today

  • Tomcat

    I was gonna hit like, but that may encourage more similar posts and I dont think my eyes can handle THAT

  • Yoda

    I think it is fair to assume that the shaking of weak longs in PMs is now over.

  • Yoda

    C’mon, admit that you desperately want to hit that ass
    😉

  • OJuice

    High yield had a good day. Closed the gap down from the 9th. Guess the majority is satisfied that the smoke has cleared and back to business as usual…

  • Yoda

    Still Draghi’s on deck tomorrow

  • OJuice

    Right… Do you know what time he fires up the smoke machine?

  • http://evilspeculator.com Sir Mole III

    How is my crew?

  • http://evilspeculator.com Sir Mole III

    Last week’s entry is starting to look pretty good!

    .

  • http://evilspeculator.com Sir Mole III

    F…ing disqus is not letting me upload the PNG.

  • Yoda

    9.00 am EST

  • Yoda

    Have not been shaken out of my long GDXJ position. All smiles today.

  • OJuice

    Great thanks.

  • http://evilspeculator.com Sir Mole III

    Excellent.

  • http://evilspeculator.com Sir Mole III

    Oh man – I’m not going to have an erection for a week.

  • http://evilspeculator.com Sir Mole III
  • http://evilspeculator.com Sir Mole III

    People have been banned for less!

  • ridingwaves

    XIV at 30.2+ since last week

  • ridingwaves

    damn, I need to get rich…

  • http://gerb-reloaded.blogspot.com/ Gold_Gerb

    no snake bites.
    this is good

  • Yoda

    or very handsome 😉

  • http://gerb-reloaded.blogspot.com/ Gold_Gerb

    How’s that naty gas widow maker doing?
    Muwahaha.
    High 3.098

    http://stockcharts.com/h-sc/ui?s=%5ENGV16&p=D&yr=0&mn=6&dy=0&id=p79331017260

  • ridingwaves

    yeah that would help, german-irish mutts rarely are attached to handsome so rich might be best avenue

  • http://gerb-reloaded.blogspot.com/ Gold_Gerb

    ..and back to the (infamous) 110 chart.
    me thinks this is a vacuous range.

    $spx
    http://stockcharts.com/h-sc/ui?s=%24SPX&p=D&yr=0&mn=6&dy=0&id=p81483776230

  • ridingwaves
  • http://ibergamot.blogspot.com/ i Bergamot

    Great article, Mole!
    And thanks for the link

    From the Epilogue:
    “MICHELANGELO: “[What is the] secret of your genius?” “Simple. I removed everything that is not David.”

  • http://ibergamot.blogspot.com/ i Bergamot

    the point of this exercise is not to make you depressed, but in a words of George Carlin:
    “Think how stupid average person is, and then realize that half the people are stupider than that”

    PS. Gold Gerb can not be destroyed. When in danger, he changes to black color of Darth and remains as such until revived by infusion of cash, bull market or a blow job 😉

  • http://evilspeculator.com Sir Mole III

    Draghi is on in five minutes…

  • http://evilspeculator.com Sir Mole III

    I think the original quote was about a statue he made. Supposedly he said that he envisioned the final work and then simply chiseled away everything around it. Which by the way is extremely difficult with marble as it has its own flow and patterns. If you don’t consider that then the statue may come out wrong or simply break when producing fine details.

  • http://ibergamot.blogspot.com/ i Bergamot

    Correct!
    I think its the same in trading, as in life.
    In words of my son: “Just don’t do stupid shit”

  • http://evilspeculator.com Sir Mole III
  • BKXtoZERO

    put TVIX back on, 17.96, today only special….. hold if it rolls over.