Saturday, April 21, 2007

Avoiding Recency Bias

As I continue to examine the factors that contributed to my less than stellar week in the markets, I keep coming back to one factor in particular. This factor is Recency Bias.

Recency bias is characterized by the tendency weigh recent data or experience more than earlier data or experience (Way of the Turtle, p. 16).

This bias in my trading was highlighted by Bill who posted this in the comments section:

Now, every once in a while you get a Feb 27th and the gap down keeps going down, and makes you look like an idiot for waiting, but the ODDS are, gap down, wait to sell.

Bill is exactly right. On Wednesday night, when I saw the Asian markets taking a beating, I began to assume that the U.S. markets would respond in a similar way as they did to the Shanghai index tanking February 27th. On Thursday morning my trading was biased towards more recent experience (February 27th). This recency bias on my part led to me assuming that instead of a gap-down and then recovery that the markets would gap down and then continue to fall throughout the day. Instead of using data from a large sample period to make my decisions, I made a decision which was influenced by a very small data set (2 months time). This was a costly mistake.

The best traders do not give recent events more weight than events of the past. Excellent traders who have mastered recency bias (and have learned how to profit from the knowledge that many other traders still suffer from this bias) bought the shares I was selling on Thursday morning.

As I begin trading again on Monday, I will not forget my over-weighing of recent events. However, I also will not dwell on my latest trading blunder, as that would give this most recent mistake more weight than mistakes I’ve made in the past, and could possibly endanger my psychological capital: confidence.

1 comment:

Dinosaur Trader said...

Excellent post! I haven't considered this as a problem, but it's something I will explore more.

I do feel like I've mentally chopped my trading career into at least 2 segments. The most recent (and unsuccesful) being the "post-hybrid market" segment. This is probably a mistake because it makes me feel like I'm a "new trader" all over again instead of thinking more about past experiences that I can still learn from that the hybrid hasn't changed.

Thanks for pointing this out. Let's kick some ass this week.