Honoring the author of this article, we find it necessary to mention that the author originally titled this article "Our Anchored Mind."
Those who have been trading, those who understand trading, should have come to discover that trading is a game of mind. Trading is all about “mind management”. Very well, one can find many trading techniques available to traders. Some may use fundamental analysis or some may use technical analysis as a map in this financial jungle known as the stock market. But in the end, there is only one thing that makes a world of difference between a winner and a loser. And that is simply how one manages their trade and emotions.
A beginner trader has always been obsessive with the analysis part and thinks that the analysis is the holy grail of trading. He/she believes that if they gain every knowledge of analysis, they can beat the market. Some even fantasize that the universe will be theirs when they shall gain all the analysis knowledge. But nothing can be further from the truth. He/she soon faces the bitter reality that despite having proper analysis skills, loss happens. Losing is inevitable. This stark experience is what breaks their illusion.
Why mind management is an inherent part of trading success?
We are human beings; we are flawed by default. No one is born with trading genes. Trading does not happen naturally to us. And to surprise, the mindset of our life we live is completely different from the mindset required for trading. Our mind is like a monkey. A restless monkey: jumping here and there creating a mess around.
Yes, our mind is full of biases that make a negative impact on our trading resulting in our Profit/Loss statements.
So, what is bias?
Bias is inclining to a view or an idea without thinking and considering the reality. And the sad news is we can never fully takeover our cognitive biases as long as we are human. Whereas the good news is we can decrease bias effects and increase the chance to become a successful trader by awareness of our cognitive biases.
This post is about one such bias that lives in the majority of the traders’ minds that leaves a negative impact on a traders’ life and profitability. It is called ‘Anchor Bias’.
How Anchor Bias Destroys Your Investment Profits
An anchor is a heavy metal object usually shaped like a cross with curved arms on a rope or chain that is dropped from a boat into the water to prevent the boat from moving away. So, Anchor bias is a bias that represents the common human inclination to depend fully on the first piece of information offered (‘anchor’) in the process of decision making. Psychologists and economists Daniel Kahneman and Amos Tversky were the first to study this.
While making decisions, anchoring happens when a person uses the very first piece of news to take a decision without considering the facts and changing scenarios. To say, you go to buy a pair of pants and among many you choose denim. What do you do? You ask about the price and the salesman tells you that the price is Rs. 3500. Now what happens next is an anchor gets set in your mind. You bargain with the seller and he offers it to you at Rs. 2900. What happens now is you feel good that you have won the bargaining game and made a final deal; a discount of Rs.600. Cool!
But what if the actual price of the pants was just Rs.2000 and the seller, aware that you would ask for a discount, raised the initial price very high? Your mind revolves only around the initial price of a pant and ignores the rest. Also, your mind starts to judge everything with respect to the anchor, here in this case Rs. 3500. This is just the beginning, furthermore, you start to look at other pants as cheap or expensive based upon if they are above Rs. 3500 or below Rs.3500. This anchor acts as your standard in making any decisions.
Now, having said that, let’s observe a few cases to understand how anchor bias impacts a stock trader:
You buy a stock @ Rs.500. The price rise to Rs. 530. You book your profits. The price then rises to Rs. 540 but you don’t buy it again. Then Rs. 550 but you don’t buy it again. Eventually, it soars to Rs.560 and you still don’t buy it.
Why? The reason for you not buying it again after booking a profit at Rs.530 is because you feel that the price has already gone higher. You begin to view the current price with respect to your initial buying price which is Rs.500 and this initial buying price becomes your anchor and the price that stock reached above the initial buying price, looks much expensive to you. Have you been there? We all have. This is why traders hesitate to re-buy positions once they are out of the trade even if that would be a profitable trade.
You buy a stock @ Rs.500. The price falls to Rs.480. You book your losses. The price falls to Rs. 470 but you don’t put a sell position (not applicable on NEPSE, you can do if you are trading commodity market). The price falls to Rs. 460 and still you don’t make a sell trade.
Why? The reason for you not selling is you feel that the price has already gone lower so that now the price may not fall more. In this case, Rs.500 becomes your anchor, and the price below it looks cheap to you. The other reason for not making sell order is because your first impression about that stock was that price would go up and so you hesitate to sell it. Your initial opinion becomes your anchor. No wonder it is harder for traders to reverse their positions after getting a stop-loss hit even if that would be a profitable trade.
You buy a stock @ Rs.500. The price rises to Rs.530. You book your profits. The price falls to Rs.510. You want to make the position again. What will be your position? Will you buy or sell? For the majority, you will buy again even if it is the wrong decision to buy.
First, since the price has come closer once again to your initial buying price of Rs.500, you feel that stock has become cheap because the initial buying price has become an anchor for you. Second, your first impression about that stock was that the price would go up, and so you can’t think of selling it. Your initial opinion becomes the anchor. Third, you also made a profit on your first trade. Remember how pleasurable a profit feels.
So, it becomes quite impossible to change your first position, your first opinion that gave you a profit. In this case, your result has become your anchor.
What this really means
If you have experienced any of this, I am sure you’ve got the image in your head. Anchor bias has affected every trader. In fact, it affects all of us in our daily circumstances. While it is impossible to free our minds of such biases as we are human beings, one can be aware of it to be on the safe side.
The majority of people look at things in the wrong order especially when it comes to trading. People believe that you need to do trading or investing to be a trader or an investor. Actually, it is the other way around. To say, apple fruits on the tree doesn’t make the tree an apple tree. It is an apple tree that produces an apple fruit. The same goes for trading. You need to be a trader first and then the trading part comes second. Remember, trading happens in your education, your mindset, your preparation to approach a trade. Buy and sell orders on the TMS are just an implementation of the vision that you already have.
So, without further ado, this simple mental practice can help every one of us to know our anchor bias and make positive changes in our life and trading. It is the ‘Fresh-Approach Practice’. What this means is to develop a habit to see every price irrespective of your previous entry price or exit price. You need to develop a habit of looking at the chart as if it is for the first time.
How to see things clearly and approach trading scenarios rationally (The Fresh-Approach Practice)
So, when you need to make a decision, have a fresh-approach at the charts and other available facts. This mental practice will help you to be more flexible. Trading is not about forecasting, it is about how we react to the information that the market is trying to show. Trading is our reaction to market action. Therefore, a reactionary posture must be flexible. A trader should not be attached to his/her opinions.
The Fresh-approach practice will help you to look at the market as it is, not as you think it is. So, either be it taking contra positions after a stop-loss hit or initiating further buy trade as the price keeps rising, you will be able to perform calmly. You only need to view every moment as a fresh moment.
Have you also observed that there are changes in your body based on how you feel? Your body posture changes. Your body contracts when you see a loss because of fear in your mind and your body expands when you see a profit due to happiness. Even your eye’s pupil dilates, your heartbeat increases, your breathing intensifies when the market moves against you and as a result, you make wrong decisions.
Have you observed this while you were trading or were you unaware of it? I believe you shall notice it in the coming days.
I thought trading was the destination. I was wrong. I discovered that trading is the journey of evolution. Everyone has to go through many stages during this journey of evolution. Enjoy the journey.
With this said I am ending this post with a wonderful quote by legendary trader Marty Schwartz.