bias, tendency It is a common occurrence in the daily life of any person. like that It applies in all areas of life, including education, medicine and economics. Most importantly, bias applies in the financial and commercial sectorsas people seem to favor some assets and styles over others.
In this article, we’ll look at a concept Halo effect How does it apply to the financial market?
Day trading itself in the early 2000s grew exponentially due to this psychological trigger, when many traders were making huge profits in the financial markets. This prompted a large number of people to start trading in order to ride this wave.
What is the halo effect?
The halo effect is a term in psychology that looks at bias in certain industries. For example, suppose you are not feeling well and you decide to go to a hospital where you find two doctors.
One of them is well dressed while the other is not. In this case, you will probably choose to use a well-dressed doctor even though the other is much better.
Many experiments have been done on the halo effect.
One of the most popular places Students of different formats take an exam. The better-looking group of students performs better than their peers when they take a physical exam. On the other hand, its performance tends to be flat when blind tested.
Halo effect in business
The concept of the halo effect It also applies in the field of business. A good example of this is that some of the better-looking individuals get some jobs, such as in journalism. The halo effect also works in administrative decisionswhich was first identified in 1920 by Edward Thorndike.
A good example of the halo effect in business is where a company and its share price are doing well. In this case, some Analysts attribute this performance to the company’s sound strategysee them LeaderExcited, impulsive employeesand a vibrant culture.
But, When conditions go wrong, people are quick to conclude that the strategy was wrong. A good example is Carvana, a company whose shares rose during the pandemic and then plummeted in 2022.
As shares soared, most analysts, including Jim Cramer, were quick to praise the company. Then they criticized the company as its stock fell.
Other companies that have done well and then slumped are Tesla, Cisco, and Vroom.
The halo effect in trading
The halo effect also occurs in day trading. that happens when Some Traders have some inherent biases in their daily business activities. There are several ways for this to happen.
Much importance on historical performance
First, traders often look at historical performance from Some assets and use of this data to make predictions. A good example of the fact that technology companies and the Nasdaq 100 are outperforming value stocks.
while this Excellence he Well documentedThe truth is, it is not always. For example, the Nasdaq 100 is down more than 30% in 2022 while the S&P 500 and Dow Jones are down less than 20%.
Herd behavior of investors
Second, traders often buy stock when a favour Investors and hedge fund managers invest in stocks.
For example, investors often buy stocks when Warren Buffet buys stocks. The theory is that Buffett is a great investor who never makes a mistake.
However, in some cases, this type of investment has been wrong because Buffett is human.
Another example of the halo effect in trading is when there is a short seller report. This is the situation where a The stock collapses after the short seller publishes a report. In most cases, stocks tend to drop sharply when prominent sellers release these reports.
Overvaluation of the company
Another example of the halo effect in trading is Corporate quality in the financial market. Sometimes, investors assume that some company or financial asset will survive grow forever.
A good example of this Teslawhose shares rose so much that its market value rose to more than a trillion dollars.
company He suffered a severe reversal in 2022 Where the company faced great competition from the likes of General Motors, Ford and Rivian.
Related “ How to trade daily reversal patterns
Another example is Netflix, which has dominated the streaming industry. The company’s shares fell sharply in 2022 as the company experienced slow growth.
Why the halo effect can be dangerous
The Halo effect can work well in some cases. In others, the strategy can seriously work for traders, and you should pay close attention to it.
Doing insufficient research
First, the halo effect can lead you to do insufficient research. This happens when a trader uses the halo effect of the current situation without doing enough research.
For example, you could buy a stock simply because of a short sale report and make a mistake.
Related “ How to do a financial stock analysis
Management change
Another risk of the halo effect in trading is known as Management changes. Sometimes, investors buy stocks because of their hope in management. However, in some cases, the CEO can leave the company or die.
When this happens, the entire thesis can change. In some other cases, the CEO could become as erratic as Elon Musk did or even lose his swag.
Use leverage
Another risk of the halo effect is the use of leverage. Leverage is the use of borrowed money in trading. For example, if you have $1,000 and leverage is 1:100, that means you can trade with $100,000.
While leverage is a good thing, the reality is that it can lead to significant challenges.
Final thoughts
There are other risks of the corona effect in the financial market. As such, you can avoid these risks by doing your own research, having a trading journal, a good trading plan, and adopting a sound risk management strategy.
Some of the best risk management strategies to use are to place a stop loss and not to leave your trades open overnight.
As long as you are a diligent trader, the halo effect is not a problem. In fact, always following your trading plan and doing research makes it easier for you to avoid this bias.
But don’t lose focus! As with all prejudices, falling victim to them is easier than you think.
Useful external sources
- The Halo Effect: Why We Buy Buffett, Bezos, and Musk Stocks Keytrade Bank