Why the market messes up your brilliant strategy.

You traded so brilliantly last year & now the market has gone & messed it up.

Holds for most of us, isn't it?

Notice something about the statement?

We attribute successes to personal skills and failures to factors beyond our control: the classical definition of SelfAttribution bias.

Self-attribution means if I pick a stock that does well, it's because I'm a genius.

If it doesn't, then there's plenty of factors that can be blamed: the economy, politicians, the company management, stock operators, Putin...

In short, success is due to my skill. Failure because of  some risk or risks that could not be foreseen.

Of course, like most cognitive biases, it doesn't hold just for investments. You can see it all over.

If we ace an exam, it is because of our intelligence, talent and hard work. But if we don't do well, it is because the rating was unfair or the professor did not teach the course properly.

When we are selected for a job, we believe that we have been hired for our achievements, qualifications and excellent interview skills. But if we aren't hired it is because the interviewer was prejudiced or there was some other hanky-panky afoot. That is how the human mind works.

The evolutionary advantage of this bias is that it causes people to persevere even after a failure - whether it was a failed hunt or a lost race. You don't lose confidence simply because you've failed. But it can spell disaster for you, especially in your investment journey.

Taking credit for successes and blaming external factors for failures underlies and reinforces investor overconfidence. Every success is attributed to great analysis and skill whereas every failure is because of "bad luck".

The result? Taking on inappropriate degree of financial risk, trading too aggressively increasing downside probability, overtrading etc are all known results. All signs of overconfidence.

It can also result in concentrated positions because you're so convinced of the brilliance of your analysis. This bias leads investors to “hear what they want to hear.”

All of these things are to be avoided!

In real life investing, both failures and successes have elements of skill and luck but in the investors mind the success is all skill and failure is all luck.

When investors/ traders are asked to attribute their previous period performance between luck and skill, they opt for a higher percentage of skill when the results have been good and more towards (bad) luck when the results have been poor.One trick which helps reduce the impact of this bias is writing down your logic for why you are taking a certain investment decision so that later on whether it turns out well or not you can go back and check whether your logic was correct. This is important even if your decision turns out right. Even if you make money on an investment, your logic for taking the position may have been totally wrong and the 'right' outcome may've been only a lucky fluke.

If you do not write your logic down BEFORE you make this investment, you can rest assured that your mind will play tricks and tell you that you always knew what really happened, which is another cognitive bias altogether that I will deal with some other time.

From the desk of Devina Mehra

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