Recency bias may not be a household phrase, but I guarantee that
anyone who has ever traded has experienced it. Recency bias is the
tendency for traders to place more importance on more recent trades and
to place less importance on less recent trades. Recency bias can have a very negative
effect on a trader's results. Let's say that two traders have the
exact same profitability over the course of 2010. However, Trader A
has won his last 3 trades, and Trader B has lost his last 3 trades.
Even though they have made the same amount of money over the year, who
do you think feels more positive? Trader A, of course. In fact,
Trader A probably feels like he can run through a wall and will never
lose again after winning 3 consecutive trades. Of course Trader A has
lost plenty of trades, but chances are the past 3 trades will make him euphoric.
Euphoria will likely lead to bad decisions by Trader A. Trader A
will ignore possible warning signs and enter a trade that typically
does not fit his criteria. This increases the odds of a loss. Shaking
his head, Trader A cannot believe he ignored those signs and gave back
some of the profits from his recent win streak. Even if he is able to
right the ship and go back to a neutral mindset, he still lost a trade
due to a mental error. Of course, every trader will lose plenty of
trades, but emotional errors (such as this one caused by euphoria) are
the reason most traders that would otherwise be successful don't live
up to their potential. If Trader A does not become emotionally neutral
after his euphoria driven loss, the damage to his account can be even
greater.
Back to our example, Trader B probably feels as if he will never win
a trade again after losing 3 straight trades. Sure, he has won plenty
of trades and is very profitable on the year. However, those 3 trades
have him thinking very negatively. Trader B will likely make one of
two mistakes at this point. First, he could abandon his rules and jump
into a trade that does not fill their trade criteria because their
criteria hasn't worked for the past 3 trades. This sounds irrational
because that same criteria has led to long term profitability, but I
would wager most experienced traders have done exactly what I just
described at some point. Second, Trader B could pass up on a perfect
trade set up that fits his criteria because he is scared of losing
again. Both scenarios can be disastrous to a trader's mindset.
Clearly, it is important to avoid these mental mistakes and minimize
the effects of recency bias. So how do we avoid succumbing to the
negative mental influences that can be caused by recency bias? The
first step is to keep a track record that includes every trade, how
much was won or lost, and total equity. That way you can accurately
track progress over a long period of time. This makes it much easier
to think about results on a long term basis. If trades are not
tracked, the past few trades will have a far greater impact on your
mindset.
The second step is to write out a trade checklist with your trading
criteria. That way, you are more likely to not enter a trade unless it
fulfills all of the criteria. You also will be more likely to enter
every trade that does fulfill your criteria. This may seem
meaningless, but it is much more difficult to ignore your trading rules
if you have to physically put a check mark next you each of your
criteria before taking a trade or passing on a trade.
The third step to minimizing recency bias is to know yourself. Some
people are more emotional than others. If you are prone to making
emotional decisions, take a day off from trading if you have lost or
won 3 trades in a row. Trading under emotional distress is not
profitable. If you handle your emotions well, perhaps waiting that day
is not necessary. Usually a full night's sleep will help negate
recency bias, especially if you have a detailed track record to go over
the next morning that reminds you long term results are more important
than the past couple of trades.
Remember, it is very challenging for the human brain to completely
overcome recency bias. However, its effects can be devastating to a
trader's mindset as well as their equity. Therefore, it is important
to take the above steps to minimize the negative effects created by
recency bias.
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