My Year as a Perma-Bear or How to Deal With Trading Biases

By root / December 9, 2017

What is a trading bias? Kurt Vonnegut wrote it once that opinions are strange things, everyone has one, but no one gives a damn about the others’. This is similar with trading biases; every trader has a view (usually a strong one) about the direction of the market, but the market doesn’t care about it one bit. So your trading bias is something personal; a thing that you have to deal with, for better or worse.

Also, there is a neat little thing that behavioral finance calls confirmation bias. This is the tendency of people to filter the information they run into in a way that they only process the “facts” that confirm their beliefs while ignoring anything that would question the “truth”. If you combine this bias with trading, you will get a real financial weapon of mass destruction.

Wait, so I should have No Opinion??

First things first, I have to establish that having a trading bias is not a bad thing; in fact, the right bias could be the cornerstone of a very successful trading period that could last for years and years. Of course, this means being bullish in a bull market or being bearish in a declining market. Having a bullish bias towards stocks since 2009 or towards Bitcoin since 2015 has been definitely a lucrative thing.

With the right strategy, you can minimize losses, or even trade with a profit in a headwind as well, but the desirable state is to have a bias that is in line with the underlying trend, while being conscious about it, and always trying to avoid the trap of confirmation bias.

When a Trading Bias gets Dangerous

Problems arise when your trading bias isn’t aligning with the direction of the market. In practice, this is not the worst thing, though, and for an experienced trader this situation is quite easy to handle.  That said, as one of my most painful trading mistakes proves, even being right doesn’t mean that you will end up with gains.

The harder part is when you have been right for a while, but the market starts to change. Changing your bias is very hard, especially when you are already conditioned that your approach is successful. This is why major turning points are so rough on traders. The good thing is that with proper money management and a good trading routine, you will notice that something is fishy before any major damage is done to your portfolio.

Managing your Biases

Routine, in general, is a good remedy against emotional mistakes and it provides great ways of identifying and dealing with your trading biases. How? It’s simple; your trading routines should reveal that your view of the market is wrong while also automatically reducing your exposure and activity level. I will show you that in practice but now let’s look at a real life example first.

My Personal Story

As I wrote in my post on overconfidence and risk management, I was heavily bearish on stocks in 2008, and even though I managed to destroy my profits once, I ended that year in the green thanks to that. The next year marked the end of the financial crisis, at least regarding US stocks, with the major indices all bottoming out in March.

Valuation metrics showed reasonable readings at that time, several technical measures were turning constructive, and the financial leaders finally went all in— basically announcing that the banks don’t have to comply with market valuation, and they will be saved no matter what.

That said, there were only a few analysts or investors screaming buy, buy, buy and I was also skeptical. Sure enough, I entered investment positions based on valuation, but I could have imagined that another year of decline was ahead of us with 20% more downside in the indices.

Waiting for the Elusive Re-Test

Long story short, throughout 2009 and up to mid-2010 I was trading stocks with a bearish bias, with a vision of a final re-test of the 2009 lows in my head, which (as we know now) never came. Confirmation bias reared up its ugly head as well; I was frustrated with bullish commentaries, and searched more and more for bearish news outlets and gurus. I wasn’t losing money, but my results were much worse than I felt they should have been.

On the flip side, I started working as a proprietary day-trader from the end of 2009 (while also managing my own savings), and the risk-management and planning techniques I learned there helped me in realizing that something is not right. One of the best methods I used was to cut back on trading in a losing streak and increase activity after a winning streak. This made me take a step back after a series of losing trades and without a position, it’s much easier to see clearly.

I also started using a trading journal and analyzing my trades more thoroughly. Those revealed that my problem was rooted in confirmation bias. Reading back the journal made it clear that I was looking for excuses to short, or to exit longs early (due to the upcoming re-test of course). Basically, I became a “Perma-Bear” for a short period, which is a very sad state in a bull market.

It would be an overstatement to say that after changing my approach it was only smooth sailing for me – there are plenty of other trading blunders to share… so stay tuned- but I became much more conscious about my biases, and much more open in my trading practices after this experience.

How to Change Biases?

For me the best way to remain flexible proved to be to try to trade in both directions all the time. Of course, I put emphasis (and commit more capital) on longs when I think that the asset is going up and vice versa, but I always try to place trades in the other direction as well.

This way there will be a clear indication that the trend is changing, as my counter-trend positions will start working while my primary trades will start failing. This method can be done without actually trading, by using a second, demo account to place the counter-trend trades if you are not comfortable with this somewhat scyzoprhenic mindset. You might say that a good trader will know when the trend changes, and you will be right in some cases, but believe me, this simple method will save you from a lot of headaches in your trading career.

Also, it is imperative to keep an open mind about your view on the assets that you trade and invest in. Always try to question your belief, and always make yourself read different opinions than your own. Confirmation bias is a nasty thing— it’s part of the self-defense mechanism of your unconscious, meaning that you have to fight it consciously.

The Takeaway and Some Timely Notes

About the current markets, if you have been reading my posts you might have already noticed, at least, some of my biases. I have a bullish view about gold, cryptocurrencies, and the Yen, while having a bearish bias towards US stocks and China and a less pronounced negative bias towards Europe, Japan, and other risk-assets.

These views are always subject to change, especially in the short-run, and I am placing trades against these biases, at least hypothetical ones, all the time. Also, my view changed on gold and not long ago, as they started behaving differently. I am also a bit suspicious about the coins following the latest incredible surge, although I wouldn’t short them with real money in this phase.

My point is that yes I have biases, but I treat them objectively not emotionally, and I won’t get offended if someone says that stocks will double in the next two years, or that gold will fall to 500. First, stranger things happened before in financial markets and, most importantly, I know that I won’t be stuck in my views if Mr. Market proves me otherwise.

So let’s sum this up:

  • Having a strong opinion about a market is good, but not knowing about the fact is bad
  • Always question the “obvious” truth and be aware of confirmation bias
  • Keep a trading journal and take the time to read it back regularly
  • Take a step back and reduce exposure after a losing streak
  • Be flexible in trading (especially short-term trading) and always try to think both as a bull and a bear

What do you think? What’s your experience with biases? Do you feel offended if someone says bad things about your favorite investment? Please share your opinion in the comments!

Great, and conscious, investing for all!

Featured image from Shutterstock

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root

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