Recency bias and its influence in trading
You will learn about the following concepts
- What does it mean?
- What are the effects of recency bias?
- What could be done in order to avoid these effects?
Have you ever wondered why every single day all of us rely on habit to do our usual activities. For example, we walk the same way to work every day, we visit the same restaurants, we shop at the same grocery stores etc. We simply rely on habit in order to do all this the easier way, because who would want to reinvent his/her life every day. However, this habit of forming habits, known as the recency bias, may prove to be a false friend, as it could urge us to make decisions we might not make otherwise. This is especially valid when trading financial instruments.
What does it mean?
Recency bias is the tendency for traders to consider of a greater importance their more recent trade performance, news or information, rather than taking into account previous performance, news or information. Recency bias has the potential to adversely affect a traders perceptions, decisions and judgement, because it can undermine overall performance.
Let us provide an example. A trader, depending on his/her trading system (based on fundamentals or technicals), may enter into hundreds of trades per year. He may achieve a greater number of losing trades than successful ones, but usually the amount of one successful trade matches at least three times the size of a loss. Let us provide two scenarios.
First, a sequence of trades may look like this:
Loss, Win, Loss, Loss, Win, Loss, Loss, Loss, Win, Loss, Loss, Loss, Win, Loss, Loss, Loss
Here we have 12 losses and only 4 successful trades, but as one profitable trade is performing three times better than one losing trade, the net effect will be 0.
Second, a sequence of trades may look also in the following way:
Win, Loss, Loss, Win, Win, Win, Loss, Loss, Loss, Loss, Loss, Loss, Loss, Loss, Loss, Loss
Again we have 12 losses and only 4 successful trades, but as one profitable trade is performing three times better than one loss, the net effect will be 0.
The net effect from the two sequences is the same, but the trader may express different feelings about his trading system at the end of the second sequence of trades. The last 8 trades on the second sequence were all losses, while on the first sequence there were 2 profitable trades out of 8. As a result, the trader may begin to doubt the reliability of his/her trading system, whether it is still valid, or does it need to be altered in order to obey the new rules, or should different indicators and a lower level of risk on the next trade be applied.
What are the effects of recency bias?
A negative effect of recency bias is the chance of changing the state of mind of a trader. There can hardly be anything worse than a huge sequence of losing trades, which can dampen his/her enthusiasm. The trader begins to question his abilities, thus falling into self-doubt. With the loss of confidence in himself/herself, the trader begins to expect weaker performance and as this inclination deepens, then suddenly bad results begin to appear.
However, positive effects of recency bias may also appear devastating for a trader. In the example above, if the second string includes 8 consecutive successful trades, this may urge the trader to become less cautious and even overconfident, susceptible to taking excessive risks, thus compromising his/her trading discipline, which may eventually lead to catastrophic consequences (financial ruin).
What could be done in order to avoid these effects?
First, every trader needs to be aware of the presence of the recency bias problem. Any memory of recent trades is likely to be lost into ones long-term memory and will not easily be remembered. Therefore, maintaining a trading journal is more than necessary.
Second, a trader needs to develop a habit to track his/her performance in the past. Having recorded an extended sequence of trading data, he/she is more likely to perceive the bigger picture in perspective.
Third, a trader needs to learn how to manage himself/herself. If he/she is put under excessive stress and anxiety, it is more likely that he/she may turn from common sense and deviate from good practices of trading. Controlling ones emotions is the key to not leave ones usual work mode.