July 12, 2019
How Stories and Experiences Impact Our Trading
Let's talk about John.
John buys a lotto ticket every Saturday, he uses the same numbers and he never misses a week.
Sometimes he rushes to the shop to buy his ticket just before the deadline because he panics that the one week he doesn't buy the ticket will be the week he would have won.
The phrase "It Could Be You" is a little reminder that maybe this time it could really be John's turn to strike it lucky!
John eventually starts to buy scratch cards and play in the other lotto games too, thinking he has a good chance of winning. He's seen winners in the paper and recently one of those winners was his exact age and had won on his first ever ticket!
John dreams about how he could buy a house with the money. This is definitely how he'll retire one day.Now let's talk about Jane.
Jane loves to go on holiday but has only been able to stay in the UK so far.
She dreams of visiting other countries and even thinks about going all the way to the other side of the world, but Jane hasn't been able to do this. Unfortunately, she has a fear of flying.
Jane has an overriding feeling that the plane is going to crash. She envisions images of plane crashes in her head, like the ones she's seen on the news and in films. She doesn't think she would make it off the plane alive.
What do John and Jane have in common?
What are the traits they are both showing here?
Yes, they both sound quite irrational, but the traits they are showing are due to something known as 'availability bias'.
Availability bias is a cognitive bias that causes us to base our judgements, or estimate probabilities, based on thoughts or stories that immediately come to mind. When we can't control our availability bias, it can lead us to think irrationally.
Understanding Availability Bias
Our brain has the tendency to recall information or stories that are more recent, extreme or dramatic, rather than things that are from further in the past or less over-the-top.
Ultimately, this can override any rational thoughts and make us believe that the first thought that comes to mind is correct.
When we look at John, we can see that the reason he still buys his lotto ticket is the thought that it could be him that wins it that time.
This is partly thanks to clever marketing and promotion using that phrase, but also from reading about the story of other winners. When we read stories like those, the images will stick in our head more than the fact that the majority of people don't win.
The number of people not winning the lottery isn't reported or publicised in the same way as the winners' stories. This means, although deep down John knows about the low probability of winning, this is not what's in his head as he's buying his ticket. Availability bias is making him overestimate the probabilities of winning.
In Jane's case, she's seen stories on the news about plane crashes and seen them dramatised in films.
Plane crashes are very unlikely, but this doesn't matter to Jane because her availability bias is causing her overriding thoughts to be focused on the crashes. This makes her thoughts very irrational and hard to overcome.
Availability Bias in the Financial Markets
Availability bias also rears its ugly head in the financial markets.
In the same way that availability bias can cause the fear of things like plane crashes or shark attacks, it can also cause fear in the markets. This can, in turn, influence our decisions about our positions.
Let's go through an example.
Adam opened a live trading account before he had taken the time to learn how to trade properly.
He got over-confident because of seeing all the "get-rich-quick" stories on Instagram and decided to chuck his entire life savings into it.
Needless to say, he eventually burnt out his account, since he didn't know what he was doing.
Fast-forward a few years, and after learning how to trade properly and getting consistently profitable results on his demo account, Adam is ready to go live. But when he does, he misses every trade opportunity that could have led to a profit.
Each time the market is going the right way, his fear takes over and he cannot open a trade. When he does finally open a position, he immediately closes it for small profits rather than letting it reach its full potential.
Availability bias is getting in the way for him and causing overriding thoughts of losing all his money again, despite knowing deep down that he has a consistently profitable approach.
What's Going On?
This example shows two different ways that availability bias can affect us.
The first way is by over-estimating the probability of winning as an amateur, thanks to stories of other traders getting rich on social media. This is just like John with his lottery ticket and the stories of previous winners.
The second way is the availability bias causing fear because of an unpleasant experience or story in the past, which stops us from doing something. This is like Jane with her fear of flying.Availability bias was studied by Nobel Prize-winning psychologists, Amos Tversky and Daniel Kahneman.
They said, "if you can think of it, it must be important." Meaning, people unconsciously assume that if something comes straight to mind without having to properly think about it, it must be more important or accurate.
They say that if you see or hear an example of something, you are more likely to think it is going to happen to you.
If you hear about your neighbour's house being broken into and burgled, you are likely to assume this is more common than it is and that it is going to happen to you next.
If a friend is in a car accident, this will be at the forefront of your mind and you will think it's going to happen to you.
When these incidents occur, they are unusual to everyday life and therefore hold more of a significance in our mind. They lead us to think they are a lot more common than they actually are. We don't truly put the probabilities into perspective.
What Should We Do?
We need to be more aware that our immediate thoughts are not necessarily facts and we should never rely on them alone. Instead, we need to use the tools that we have at our disposal.
If we are making decisions in the financial markets, we should be trusting in our analysis and systems, instead of relying on a hunch.
Any irrational fears in our personal lives, such as fear of flying or fear of burning out our account despite our wealth of experience, can be improved by learning the true statistics of the likelihood and realising it is maybe not as common as our availability bias leads us to believe.