Have you ever felt like the market was trying to “trick” you? Does it sometimes seem like it knows what you’re going to do before you do it, as if it’s waiting to stop you? If so, you’re not alone. This is something that most traders have to deal with at some point in their careers, and you may be dealing with it right now.
In today’s lesson, I’ll talk about a thing called “recency bias” or “the recency effect” and how it can hurt your trading and make it look like the market is trying to trick you on purpose. Then, we’ll talk about a few things you can do to avoid recency bias and the bad things it can do to your trading account.
Are you too focused on the “trees” to see the “forest”?
When people are asked to remember a list of things in any order, those at the end of the list are more likely to come to mind than those at the beginning. This is called the recency effect.
The recency bias or effect is what happens when a trader puts too much weight on his or her most recent trades and loses sight of the bigger picture. When a trader has recency bias, they can’t see the big picture.
In his book Your Money and Your Brain, Jason Zweig writes, “It is human nature to judge odds based not on long-term experience but on a small number of recent events.”
How many times have you left a trade with a 2:1 risk-to-reward profit, only to see the market move in your favor for another 2 or 3 times your risk without you? When this happens, it’s natural to think to yourself, “Next time I’ll hold the trade instead of taking the 1:2 risk:reward,” and then the next few trades don’t run; instead, they reverse after hitting what would have been a 1:2 risk:reward. But because you had recency bias, you chose to base what you would do on your next trade(s) on what happened on your most recent trade(s). Instead of making a 1:2 risk reward, you lost money because you were too committed to holding the trade.
On the other hand, you may have been in trades that you planned to hold for a while but saw them go against you after they hit a 1:2 or 1:3 risk-reward ratio. So, you decide to get out of the next trade or trades when the odds are 1:2 or 1:3. You do this, and the trade keeps going in your favor without you.
After a while, situations like these can make you feel like you’re going crazy. This is because you’re putting too much weight on your most recent trades, which is called a “recency bias.”
You need to know that if you want to be a successful trader, you need to make decisions based on facts and stick to your trading plan and strategy. If you make every trade decision based on what happened with your last trade or few trades, you’ll feel like the market is “tricking” you because you’re making decisions based on feelings and emotions instead of logic, facts, or strategy. When you trade with expectations based on how you’ve done in the past, you’re setting yourself up to feel “tricked” by the market because it probably won’t do what you want or expect it to do. Even if it does what you want, making trading decisions based on the results of your most recent trades is a very bad habit that will cause you to lose a lot of money in the long run.
- The trap of learning from the past
- trap of hindsight
I like to call recency bias a “trap for learning with hindsight,” because that’s exactly what it is: a trap. You fall into a trap when you think that just because the market did XYZ on your last trade, it will probably do XYZ again. In fact, none of this is true at all. The market will do what it wants when it wants, and it doesn’t care what happened with your last trade.
It’s important to remember that your trade results are based on a large sample of trades, not just the few you’ve made recently. You need to look at your trading results over a period of 6 months to a year to get a good idea of how you trade and how good you are at it. Just as it is dangerous and misleading to make trading decisions based on charts with lower time frames, it is also dangerous and misleading to make trading decisions based on too small a sample of your trading results.
Instead of thinking about the bigger picture and sticking to your trading plan, it’s easiest to focus on what happened most recently. It may be in our nature to want to believe that what just happened will keep happening, but in trading, this is usually not the case, and as we’ve talked about, it can get you into a lot of trouble.
How to keep the big picture in mind
To avoid recency bias, you need to keep your mind on the “forest” instead of the “trees.” In other words, you need to keep your mind on the bigger picture. Here are some things to remember and suggestions to help you avoid recency bias…
Remember that there will be a random number of winners and losers with any trading edge or strategy. This means that even if you’re winning most of the time, say 55% of the time, you can’t tell if a particular trade will be a winner or a loser because they’re all picked at random. So, this should help you see why planning your next trade based on your most recent trade(s) is illogical and counterproductive, or, in other words, it just doesn’t make sense.
Focus on each trade as if it has nothing to do with the others, because it does. Even though the market ran 400 pips in your favor on your last trade, that doesn’t mean it will do that again. If anything, it’s probably less likely to do that again since it just did it. The market is basically set up to trick you, and recency bias will trick you if you aren’t constantly aware of what you’re thinking and doing every minute.
You might just need to take a break after a trade, whether it was a winner or a loser. Take at least a day or two off from the markets to calm down and get your thoughts together. Before you look at the charts again when you get back, go over your trading plan and keep in mind the bigger picture.
Keeping a record of your long-term performance or a trading journal is a great way to keep an eye on the bigger picture. Keeping track of your long-term and overall trading performance will give you the trading perspective you need to make decisions based on facts instead of being too influenced by recent trades or returns.
You can also avoid recency bias by sticking to your trade selection criteria and goals. This will help you trade with discipline rather than based on how you feel. You might find it helpful to make a simple list of all the things you look for in a good price action trade signal. This will make it less likely that you’ll make your next trade decision based on how confident you are after a recent win or how hesitant you are after a recent loss. Instead, you’ll be more likely to stick to your trading plan.
The last thing you can do to avoid recency bias is to know yourself and always be aware of yourself when trading or analyzing the market. You can think of trading as the most difficult mental “game” you’ll ever play. To win, you need a strong sense of who you are and a good understanding of yourself. As a trader, it’s all too easy to get caught up in a recency bias and not even know it. You need to keep an eye on your trading thoughts and actions at all times to make sure you’re acting based on logic and facts, not feelings. As we talked about above, you can help yourself do this by keeping a trading journal and following your trading plan.
All trading mistakes happen when people act on their feelings instead of making decisions based on facts and objectivity. Recency bias is the same. You are making too many decisions based on your most recent trading results, mostly because of how you feel after those trades. I’ll admit that it’s not hard to figure out what’s wrong, but it’s much harder to figure out what’s wrong “in real time” and stop yourself from doing it.
Recency bias and other trading mistakes are hard to avoid, but you can get past them if you work hard and trade with discipline. This means that you have to make a conscious effort to get past them, because we humans are not built to trade well if we just go with our natural tendencies. If you follow the tips I talked about in today’s lesson, you’ll be able to see the bigger picture in your trading and stop letting your most recent trading results have too much of an effect on your next trading decision.
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- Warren Buffett
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