Brain Traps: Common Cognitive Biases
Losing $100 hurts about twice as much as winning $100 feels good. That imbalance is exactly what makes people cut their winners and cling to their losers.
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Text version · Risk Management & Trading Psychology, lesson 6: “Brain Traps: Common Cognitive Biases”
Losing $100 hurts about twice as much as winning $100 feels good. That imbalance is exactly what makes people cut their winners and cling to their losers.
Loss aversion
loss aversion makes us hold on to losing trades just to avoid the pain of admitting a loss. The disposition effect is what that looks like in trading.
Overconfidence and recency bias
After a few wins, overconfidence leads to bigger positions and looser stops; recency bias makes people think the latest trend will go on forever.
Sunk cost
“I've already lost so much, I can't sell now”: that's the sunk cost fallacy. The right question is always: if I had no position right now, would I buy it?
Key takeaways
- Loss aversion: for the same amount, a loss feels much stronger than a gain, about 2x in studies.
- Disposition effect: rushing to sell winning positions while holding on to losers, the exact opposite of "cut your losses and let your profits run".
- Overconfidence, recency bias and the sunk cost fallacy all quietly change your decisions.
- The antidote is rules written in advance: set your stop, target and size before you place the trade, and simply follow the rules when you execute.
Try it yourself
You can do these exercises in this lesson's interactive simulation:
- In the “Feeling curve”, drag the amount to +$500 and −$500: how much happiness and how much pain?
- Set the loss-aversion coefficient λ to 1: how many times the happiness is the pain? Is the curve symmetric now?
- Set λ back to 2.25 and drag the amount from +$100 to +$1,000: the money is 10 times bigger, but is the happiness 10 times bigger?
- Switch to “Which one do you sell?”, pick one on instinct, then read the explanation.
Quiz and explanations
- 1. "Sell as soon as it's up a little, hold losers until they come back": which bias is this?
- Answer: Disposition effect.The disposition effect: cashing in gains too early and putting off admitting losses.
- 2. "I've already lost so much, I can't sell now" is an example of…
- Answer: The sunk cost fallacy.Losses that have already happened shouldn't affect your decision now. What matters is the odds from here.
- 3. After 5 wins in a row, you raise the risk on your next trade from 1% to 5%. Which bias is most likely at work?
- Answer: Overconfidence.A few good results make people overestimate their skill, so they size up and loosen their discipline.
Terms in this lesson
- disposition effect (Disposition Effect): Selling winners too early and clinging to losers, the exact opposite of “cut your losses and let your profits run”.
- loss aversion (Loss Aversion): Losing a sum hurts about twice as much as winning the same sum feels good.
- overconfidence (Overconfidence): Overrating how accurate your judgment is, so after a few wins you size up and loosen your stops.
- recency bias (Recency Bias): Giving too much weight to what just happened and assuming the latest trend will keep going.
- sunk cost fallacy (Sunk Cost Fallacy): Refusing to let go because you've already put in (or lost) a lot; decisions should depend only on the odds from here.