Trading Biases (Part 2)

16.1 – Anchoring Bias

I’ve spent close to about 13 years participating in the stock markets. I’ve spent these years in various capacities – as a trader, investor, broker, money manager, analyst etc. I’ve had my fair share of happiness and regrets in the markets and I’ve learned a lot (still continue to learn) during these years. I’ve realized that happiness and regret may not always be a linked to the outcome of a trade that you’ve taken up – you feel happy when you make a profit and regret when the trade results in a loss. These feelings can also manifest out of trades that you’ve not taken up. Let me tell you one of my biggest regrets in the stock markets till date.

I the recent years, August / Sept 2013 was one of the greatest times to build a long-term portfolio from scratch.  Stocks of great business were available at throwaway valuations. I was fortunate enough to be aware of this situation in the market and I was really busy structuring my equity portfolio. I had a tough time selecting stocks to include in my portfolio. Tough time in the sense that there were too many opportunities to choose from. In fact, this is what a bear market does to you – it spoils you for choices.

I included few stocks in the portfolio (which I still continue to hold) and I let go of many stocks including MRF, Bajaj Finserve etc. The decision to let go of these stocks was based on the fact that I perceived investing in other stocks more attractive. Stocks like MRF and Bajaj Finserve have performed phenomenally well, but then I don’t regret my decision.

However, the decision to not invest in Sundaram Clayton Limited pains my heart – I consider this as one of the biggest regrets.

I did my usual stock research and was convinced that the stock was a great buy. I’ve circled the area around which I wanted to buy – roughly around 270 per stock. Given that it was a bear market, I was kind of rigid on the price to buy – 270 or lower.

The stock price moved slightly higher to about 280, but I did not budge. I waited. The stock price moved to 290, I waited. A couple of days later, the stock shot to 310 and I remember convincing myself – the stock will retrace back to 270 considering that it was a bear market. After all, I was in no mood to pay a 15% ‘premium’ on a price that I perceived as ‘the best price’.

As you may have guessed, 270 never occurred and I never got to buy this stock, and here is what really happened to the stock later on –

I’ve circled the 270 price mark again for your reference, which is where my so-called ‘price conflict’ occurred – all in my mind!

I probably missed out one of the greatest investment opportunity in my life, and all thanks to the games my mind played with me. More formally, what really prevented me from buying Sundaram Clayton can be attributable to a notorious trading bias called ‘The Anchoring Bias’.

I was looking up on Wikipedia for ‘Anchoring Bias’, and I discovered a new term for the same – it is also called ‘Focalism’. Anchoring bias belongs to a group of biases grouped under ‘Cognitive Biases’. Cognitive bias is a systematic error in our thinking that affects the way human beings make their decisions or judgments. Anchoring Bias leads the list of cognitive biases.

Under the influence of Anchoring Bias, we tend to get fixated to the first level of information we get. For example, in my very own case, the first price I saw on the terminal was 270 (for Sundaram Clayton), and I was fixed to that price. Here 270, formed a price anchor.

Think about your own trading situations – how many times you may have missed placing that buy order or a stop loss order because the price that you perceived as ‘right’ never occurred, only to later see the stock perform exactly the way you thought it would. After all, in most of these situations, the price difference between what we perceived as right and the one available in the markets would be marginal – few Rupees probably, but then our minds just do not permit us to go ahead.

Like any other biases, there is no real cure for anchoring bias. The only real cure is to be aware of it and adopt critical thinking in your approach to markets.

16.2 – Functional Fixedness

This is yet another cognitive biases – although you will not read much about this particular bias in the trading world. However, I think it kind of has its impact on traders, especially the ones who trade derivatives.

Let me give you a generic explanation of ‘functional fixedness’ bias and then relate this to the trading world.

There is juice shop near my office which I frequent for a glass of fresh juice. On one of those visits, I asked for my regular orange juice, but the guy at the juice shop was busy fixing the mixer jar. The handle of the jar was loose and had to be fixed. The guy was busy trying to find a screwdriver to tighten the mixer’s handle. Unable to find one, he was kind of clueless on how to proceed.

At the same time, his colleague walked in and learned about the issue. He simply picked up a spoon which was lying around, used the other end of the spoon (which basically has a flat side) as a makeshift screwdriver and tightened the jar. Problem solved, juice was served.

This is functional fixedness at its best. Functional Fixedness is a cognitive bias that limits a person to using an object only in the way it is traditionally used. We assign tasks to objects and we live with that rigidity all our lives. For example – we have all grown up with the notion that we only need to look for a screwdriver to tighten screws, without which one cannot. However, a simple spoon can do the same job! One has to start thinking out of the box to solve problems in unconventional ways.

There are few ways in which Functional Fixedness limits our way of thinking when it comes trading. Let me start with a classic example.

Assume you have Rs.100,000/- in your trading account. You have identified a great trading opportunity in Nifty and you expect to hold onto the trade for the next 2 or 3 days.  Since you intend to hold this trade overnight, you have to opt for a ‘NRML’, product type.  The typical margin blocked for this trade would be about Rs.65,000/-.

So you take the trade around 3:20 PM and carry the position forward. End of the day 65K would be blocked as margin and 45K would be your available balance, which can be utilized toward another trade the next day.

The next day market opens, Nifty starts moving in the direction that you expect it to move. You are happy with the way things are going.

Now, assume that you spot a great intraday opportunity, TCS stock futures, which requires you to pay an MIS margin of 60K. What will you do? The available margin is 45K, you’d fall short of 15K right? Therefore you cannot take the TCS intraday trade.

Now, this is where the functional fixedness is playing the culprit. We consider the NRML (margins blocked for overnight positions) as ‘margins blocked’, and we invariably forget about this capital until we square off the position.

With a little bit of ‘out of the box’, thinking (and some efforts) we can, in fact, continue to hold the overnight position plus take up the intraday opportunity.

Here is how it would work –

1. At the start of the day, you have available margin of 45K, short of 15K to take up the intraday trade
2. Convert the NRML Nifty position to MIS. When you do this, from the 65k that was blocked, nearly 39K would be freed up – as MIS for Nifty is about 26K
3. You now have 45K + 39K or 84K free cash for the day
4. With 84K, you can easily place an MIS order, blocking 60K. You will still have 14k as available margin
5. End of the day, square off the MIS stock futures trade – remember this was an intraday trade
6. Your available margin goes up to 84K
7. Convert back the MIS Nifty trade to NRML and carry forward the position

16.3 – Confirmation Bias

I’ve marked few important points on this chart –

1. The stock is around 430 today
2. 430 seems to be a price action zone considering the past price reactions
3. Sometime in early August, the price cracked through 430 and declined to 370
4. The stock price stabilized around 370, quite evident with the double/triple bottom formation
5. Since 370, the price has consistently trended up, all the way back to 430, which is where the current stock price is

Considering the above, guess the stock is all primed up for an up move – don’t you think so?

Also, keeping that analysis in the back of our mind how would you view this piece of news which made the headlines earlier today –

Chances are that you will views this news piece as a trigger for Tata Motors to edge higher and therefore support your logic of buying the stock. However, in reality, the fundamental news may not really be a great trigger to drive the stock price higher. But then, at a subconscious level, you start looking for pieces of information that support your view. In other words, when you form a trading opinion, no matter what happens, you only look and assimilate information that supports your view. Your brain somehow does not allow you to pay attention to information that does not support your original contention.

This is called the ‘Confirmation Bias’.

Critical reasoning is the key to overcome the confirmation bias. You got to ask yourself – so what?

16.4 – Attribution Bias

This one is funny.

How many times have you had a winning trade and ended up feeling proud of your analysis? Perhaps you bought an option and it gained 100% on the premium or maybe you bought a stock and saw it appreciate multifold.

Every time you make a profit – it is somehow because of your smart trading logic, and therefore you give yourself a pat on your back. But what about the times you’ve made a loss? How do you deal with it?

Coming from a stockbroking industry, let me tell you one thing – when people make a loss, they invariably attribute this as broker’s fault and not really their own. Traders find all sorts of reasons to blame the broker – broker’s system failed, charts not loading, orders are slow, and what not.

Everything thing is attributable to someone else’s mistake (mainly the broker) and not really the subpar analysis in the first place!

This is called the ‘Attribution Bias’ and people succumb to it owing to acknowledge the fact that they are wrong. One way to overcome the attribution bias is to maintain a trading journal and make entries which reason outs why you’ve entered into a trade and why you decided to close the trade. These journal entries over time give you a great insight into your own trading behavior.

16.5 – And it’s a wrap!

The list of these biases gets endless. Naturally, covering all of them would be hard. However, here is what I’ll do – I’ll keep this chapter open and I will continue to add more biases as and when I discover them myself ☺

With this chapter, I’d like to close this module on Risk and Trading Psychology. As usual, I hope you enjoyed reading this module, as much as I enjoyed writing it for you all.

Keep those comments coming!

Key takeaway from this chapter

1. Anchoring Bias can be quite notorious – tricks the trader/investor to anchor them to the first piece of information
2. Anchoring Bias may lead you to miss great opportunities
3. Functional Fixedness fixes your opinion on the utility of the tools, restricts your imagination
4. One can overcome functional fixedness by practicing ‘out of the box’ thinking approach
5. Confirmation bias makes you seek information (or tricks you to assimilate information) which can support your original hypothesis
6. In a typical trading world, traders attribute losses to problems in the outside works and not really because of subpar analysis
7. Attribution Bias can be overcome by maintaining a trading journal