What Are Cognitive Biases?
Cognitive bias refers to the psychological phenomenon where human thinking and judgment systematically deviate from rational reasoning. Behavioral finance research has found that these biases directly affect our investment decisions, leading to predictable loss patterns.
The good news is: once you recognize the existence of these biases, you can reduce their impact through institutionalized methods - and systematic strategies are the best tool for replacing intuition with data.
Bias 1: Confirmation Bias
What Is Confirmation Bias?
Only paying attention to information that supports your views while automatically ignoring or rejecting contrary evidence.
How Confirmation Bias Shows in Investing
You are bullish on a stock, so you:
- Pay special attention to positive news and ignore negative warnings
- Only read analyst reports that are bullish on the company
- Only discuss with people on social media who agree with you
How to Counter Confirmation Bias
Before making any trading decision, force yourself to answer: "What factors could cause my judgment to be wrong?" Create an opposition list, listing all the negative factors you do not want to see. Use a trading journal to review whether you had biases at the time.
Bias 2: Loss Aversion
What Is Loss Aversion?
Psychological research shows that the pain of loss is approximately twice as intense as the pleasure of gain. That is, losing $100 hurts as much as gaining $200 feels good.
How Loss Aversion Shows in Investing
- Taking profits too quickly when winning (afraid profits will disappear)
- Holding onto losing positions stubbornly (unwilling to accept a realized loss)
- This asymmetric behavior inevitably leads to long-term losses
How to Counter Loss Aversion
Set clear stop-loss and take-profit rules, using systems to replace feelings. See Seven Ways to Conquer Fear and Greed for position control and plan execution strategies.
Bias 3: Endowment Effect
What Is the Endowment Effect?
Once you own something, you overvalue it and are unwilling to sell it at a fair price.
How the Endowment Effect Shows in Investing
After buying a stock, even if fundamentals deteriorate and technicals weaken, you still refuse to sell. You tell yourself: "This stock should be worth more," "It will come back in a while."
How to Counter the Endowment Effect
Ask yourself one key question: "If I did not own this stock right now, would I buy it at today price?" If the answer is no, you should consider selling.
Bias 4: Recency Bias
What Is Recency Bias?
Overweighting recent experiences while ignoring long-term trends and statistical data.
How Recency Bias Shows in Investing
- After a few winning trades, becoming overconfident and increasing position size
- After a few losing trades, becoming overly pessimistic and afraid to enter
- Mistaking short-term luck for long-term skill
How to Counter Recency Bias
Evaluate your trading performance over a longer timeframe. Do not judge a strategy based on 5 trades - you need at least 50-100 trades for statistical significance. For more on mindset during losing streaks, see The Right Mindset During a Losing Streak.
Bias 5: Anchoring Effect
What Is the Anchoring Effect?
Over-relying on a reference point to make judgments, even if that reference point is irrelevant to current conditions.
How the Anchoring Effect Shows in Investing
- Clinging to purchase price: "I bought at $100, I am not selling until it comes back"
- Using previous highs as targets: "It once reached $150, it will come back"
- In reality, the market does not care about your purchase price
How to Counter the Anchoring Effect
Focus on current fundamentals and technicals, not historical prices. Your purchase price has no relationship with the market future direction.
Bias 6: Overconfidence
What Is Overconfidence?
Overestimating your knowledge, skills, and judgment accuracy while underestimating the role of luck and risk.
How Overconfidence Shows in Investing
- Believing you understand the market better than others
- Frequent trading because "every entry feels confident"
- Ignoring risk management rules because "this time is different"
How to Counter Overconfidence
Let the data speak. Record the win rate and profit-loss ratio of every trade. When you discover your win rate is only 50%, overconfidence will naturally be corrected by reality. See Institutional vs Retail Gaps to learn how to evaluate yourself systematically.
Bias 7: Herd Mentality
What Is Herd Mentality?
Following what most people are doing without independent thinking.
How Herd Mentality Shows in Investing
- Seeing everyone on social media chasing a stock and immediately following
- Panic selling when seeing market panic
- Having no judgment of your own, completely relying on others opinions
How to Counter Herd Mentality
Before making any trading decision, ask yourself: "Is this my own judgment, or am I doing it because everyone else is?" FOMO (Fear of Missing Out) often accompanies herd mentality, and together they form the biggest psychological trap for retail investors.
Summary of Seven Psychological Biases
| Bias | Core Problem | Key Response |
|---|---|---|
| Confirmation Bias | Only seeing information you want to see | Create an opposition list |
| Loss Aversion | Fear of losses | Set rules, use systems to replace feelings |
| Endowment Effect | Overvaluing assets you hold | Ask "Would I buy this today?" |
| Recency Bias | Overweighting recent experience | Evaluate over longer timeframes |
| Anchoring Effect | Clinging to reference prices | Only look at current fundamentals |
| Overconfidence | Overestimating your ability | Let trading data speak |
| Herd Mentality | Blindly following the crowd | Think independently before deciding |
How to Systematically Fight Cognitive Biases
Step 1: Establish Trading Rules
Write entry and exit conditions as clear rules - the Strategy Center provides a complete data-driven trading framework instead of relying on feelings. Once rules are set, strictly follow them.
Step 2: Keep a Trading Journal
Use a trading journal to record the thinking process behind each trade. When reviewing later, you can clearly see which biases affected you.
Step 3: Regularly Review Decisions
Set aside time each month to review your trading records from the past month, identifying which decisions were rational and which were affected by biases.
Step 4: Accept Your Imperfection
No one can completely eliminate cognitive biases. The goal is not to become a perfectly rational decision-maker, but to build systems that minimize the impact of biases.
Summary
Cognitive biases are part of human nature. They cannot be eliminated, but they can be managed. The key is:
- Recognize biases - first know they exist
- Build systems - use rules to prevent biases from interfering with decisions
- Track continuously - observe your behavior patterns through a trading journal
Remember: good traders are not without emotions - they know how to prevent emotions from affecting decisions. Explore the Strategy Center and use data-driven trading systems to overcome cognitive biases.