Psychology is an important concept In day trading and investing. In centuries past, some popular traders and investors failed simply because they didn’t manage themselves well.
For example, the collapse of Long-Term Capital Management (LTCM) was mostly due to psychological reasons.
In the past we have looked at the concept of overconfidence bias, anchoring bias and novelty bias because we feel these are aspects of psychology that need to be known.
In this article, we will look at a concept optimism and a bias towards pessimism and how it can affect a person’s trading results.
What is the optimism bias?
Optimism is defined as optimism and confidence in the future for a thing or situation. As such, optimism bias is defined as the situation in which one believes they have Reduce the risk of experiencing difficult situations or poor results.
This cognitive status is caused by several factors such as their environment, upbringing, and past successes.
The optimism bias is often confused with the overconfidence bias. people who are Overconfidence tends to lead to extreme optimism. However, the two are slightly different.
For example, Overconfident people tend to rely on their experiences. For example, people with many years of experience in an industry tend to think they can make few mistakes.
A good example of the optimism bias occurred during the COVID-19 pandemic. At the time, some people with this prejudice believed they could not catch the virus. Then most of these people avoided taking the vaccine.
What is the pessimistic bias?
Pessimism is the exact opposite of optimism. It is defined as a state in which you are less optimistic about the future. pessimists She tends to be negative in many situations.
In most cases, the pessimism bias tends to overestimate the likelihood of negative events compared to positive ones. Being pessimistic has several effects, including failure to take risks and even depression.
The effect of optimism bias in day trading
Ignore the risk factors
There are several effects that the optimism bias has on day traders. First, the optimism bias leads to Risk minimization in the market or in a strategy.
When you are very optimistic, you tend to believe that the strategy will work well. As such, you will often fail to implement basic risk management strategies such as having a stop loss, failing to place your trades well and using excessive leverage.
Second, optimism bias can Pushing the trader to trade excessively. This happens when one opens too many trades per day and expects each one to be profitable.
In most cases, excessive trading is one of the most dangerous things one can do. It often results in huge losses since the trader usually does not do much analysis.
The other major danger of the optimism bias is that traders tend to Overestimating its current and expected returns. In most cases, when you are very confident, you will often think that the expected returns in your account will be higher.
As a result, this can lead to overconfidence, which can lead to huge losses in the future.
Ignore contradictory opinions
Moreover, optimism bias can lead people to this Ignore any opinions that contradict theirs. For example, if you strongly believe that a stock will go up, you will buy it even when there are signs of it going down. A good example of this is what happens in a bull market.
In such a market, people with a penchant for optimism often buy newly listed companies even when they have weak fundamentals. We saw it during the dot-com bubble and during the covid-19 bubble.
The most important consequence of the optimism bias is this It leads to poor returns to the merchant. When you are very optimistic and confident, you are likely to make small mistakes when trading or even when investing.
Ignore the in-depth analysis
All this can be summed up as: Ignore the in-depth analysis before opening a deal or investment. When you are optimistic, you often ignore the basic facts when opening a trade. As such, this may lead to further losses.
Related “ Wise traders should believe in analysis, not prediction
The effect of pessimism bias in day trading
Pessimism bias also has many important effects in day trading. Some of the most significant effects of pessimism bias in trading are:
- Close deals too early – When you are very pessimistic about the market, you are likely to close your trades very early. As such, you will often do Leave some profits on the table.
- Exposed bias When you have a pessimistic bias about a company, you will be biased towards opening short positions. Short selling is riskier than buying because your maximum loss potential is infinite.
- Avoid opening deals Another effect of the pessimism bias is that you will often avoid opening trades for fear that you will make more losses.
- long wait for confirmation.
The emotional state has changed
In our introduction we talked about some biases related to excessive optimism/pessimism, but these two can affect our state of mind (and our emotions) in other ways as well.
The best example is the chance of falling victim to fear/greed, and we know how dangerous this state of mind can be to our detriment.
Here, trading with the fear of making a wrong game, or with the greed of making a lot of profits in a short time, is likely to lead you to huge losses.
You can’t overlook the FOMO (fear of missing out) and availability bias here. In short, a little bit of optimism and fear is healthy – too much of it can have unpleasant consequences!
Reasons for optimism and pessimism
There are several reasons for optimism and pessimism. Firstly, your trading experience This bias can lead. For example, if you have a long experience as a profitable trader, the effect is that you may have some optimism bias.
second, Social media This bias can lead. If the people you follow are very optimistic about the market, you will most likely be optimistic about an asset as well. Media hype in Susya It can lead to this kind of bias as we saw during the meme stock mania.
finally, today’s news This bias can lead. For example, when the news is extremely negative, it can create a pessimistic bias that causes you to buy short stocks.
How to identify them and find balance
All of the above information that we have provided you seems to paint a catastrophic scenario, where we cannot afford to let loose and keep our emotions in check all the time.
However, this is not possible, but it is not necessary either! All we have to do is find the right balance, and there are many opportunities to do so:
- Having a good risk/reward ratio is the foundation for a balanced career.
- Create and maintain a trading routine (with some flexibility!).
- Have a trading plan to follow that reflects our daily goals needs
- Work in teams, especially in a trading desk, to compare with other traders
We all have optimism and pessimism biases. Therefore, the right thing to do is to identify your bias and Then find balance between the two.
Most importantly, you should focus on doing your research on the assets and then making informed decisions.
Useful external sources
- Bullshift: How the optimism bias threatens your investments and your finances – Finance Post