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Have you ever felt like the market is trying to ‘trick’ you? Does it sometimes seem like it knows what you’re going to do before you do it, almost as if it’s waiting to counter your next move? If so, you’re not alone. Most traders have experienced this at some point in their careers, you may even be struggling with it right now.
In today’s lesson, I’m going to discuss something called recency bias or the recency effect, and how it can negatively affect your trading and make it seem like the market is purposely trying to trick you. We will then discuss several possible solutions to help you avoid recency bias and the devastating consequences it can have on your trading account.
Are you losing the ‘forest’ in the ‘trees’?
In psychology, recency effect is the phenomenon that when people are asked to recall in any order the items on a list, those that come at the end of the list are more likely to be recalled than the others.
In trading, the recency bias / effect is when a trader focuses too heavily on his or her most recent trading decisions / trades and loses perspective on the bigger picture. In other words, when a trader has recency bias, they can’t see the forest for the trees, so to speak.
In his book Your Money and Your Brian, Jason Zweig explains, “It is human tendency to estimate probabilities not on the basis of long-term experience but rather on a handful of the latest outcomes.”
How many times have you experienced a situation where you exited a trade with perhaps a sold 1:2 risk reward profit, only to see the market continue on in your favor another 2 or 3 times your risk, without you on board? When this happens, it’s natural to make a mental note of it and think to yourself, “next time I will hold the trade instead of taking the 1:2 risk : reward”, and then inevitably what happens is the next few trades don’t run, instead they reverse after hitting what would have been a 1:2 risk : reward. But, since you had recency bias, you chose to base what you would do on your next trade(s) from what happened on the most recent trades, and instead of making a 1:2 risk reward, you actually lost money because you were over-committed to holding the trade.
Conversely, you may have also been in trades that you were planning on holding for a while, only to see them reverse after hitting a 1:2 or 1:3 risk reward. As a result, you plan to just get out of the next trade or trades around 1:2 or 1:3, you do so, and then the trade continues rocketing on in your favor without you on board.
Situations like these can really make you feel like you’re going mad after a while, and they are the direct result of putting too much emphasis on your most recent trades, or having a ‘recency bias’.
You need to understand that being a successful trader takes objective decision making and discipline to stick to your trading strategy and trading plan. If you start basing every trade decision on what happened with your last trade or last few trades, you’re going to feel like the market is ‘tricking’ you because you’re basically operating purely off feeling and emotion, instead of logic and objective / strategic decision making. When you trade with some expectation based off your recent trading results, you’re setting yourself up to feel like you’re being ‘tricked’ by the market because it’s most likely not going to do what you expect it to or want it. Even if it does do what you expect, basing trading decisions on the results of your recent trades is essentially an emotion-based trading behavior and a very bad habit to form, and will eventually cause you to lose a lot of money.
The hindsight learning trap
hindsight trapI like to think of recency bias as a ‘hindsight learning trap’, because that’s really what it is; a trap. You trap yourself by thinking that just because the market did XYZ on your last trade, it’s likely to do XYZ again. In reality, this is simply not true at all. The market will do what it wants when it wants, and it doesn’t care what happened on your last trade.
It’s critical to keep in mind that trade results are measured over a large sample of trades, not just your last few. You need to measure trading results over a 6 month to 1 year period to really get a good idea of your trading habits and your skill level. Just like paying too much attention to lower time frame charts is very dangerous and misleading for making trading decisions, so is paying too much attention to too small of a sample of your trading results.
It’s easiest to focus in on what happened most recently instead of thinking about the bigger picture and sticking to your trading plan. It is perhaps part of our human nature to want to believe that what has happened most recently will continue to happen, but in trading this is simply not true most of the time and as we’ve discussed, can get you into some serious trouble.
How to keep your eye on the bigger picture
In order to avoid catching recency bias, it’s critical you remain focused on the ‘forest’ instead of the ‘trees’, in other words, stay focused on the bigger picture. Here are some things to keep in mind and tips to help you avoid getting recency bias…
Remember that any trading edge / strategy is going to have a random distribution of winners and losers. This essentially means that even if you’re winning overall, say 55% of the time, you still can never know if any particular trade will be a winner or loser, since they are randomly distributed. Therefore, this fact should help you to see why basing your plan of action for your next trade on your most recent trade(s), is simply not logical and is counter-productive, or in other words, it just makes no sense.
Focus on each trade as if it’s totally unconnected to your previous trade(s), because it is. Just because the market ran 400 pips in your favor on your last trade does not mean it will do that again, in fact if anything, it’s probably less likely to do that again if it just did it. The market is basically designed to trick you, and if you aren’t constantly consciously aware of what you’re thinking and doing every minute in the market, you will get tricked by recency bias.
You may need to simply take some time off after you exit a trade, whether it’s a winner or loser. Take at least a day or two away from the markets to collect yourself and let your emotions simmer down a bit. When you come back, review your trading plan before you look at the charts again and remember what the bigger picture is.
Keeping a record or a trading journal of your long-term performance is a great way to keep the bigger picture in mind. Logging the long-term / overall performance of your trading will help you gain the proper trading prospective that you need in order to make your decisions based on facts rather than being overly-influenced by recent trades or returns.
Another way to overcome recency bias is to stick to your trade selection criteria and goals, this will work to instill disciplined trading in you rather than emotion-based trading. It helps if you can come up with a simple checklist of all the criteria that you look for in a high-quality price action trade signal. This will make it less likely that you’ll base your next trade decision on overconfidence from a recent winner or hesitation from a recent lower, and will make you more focused on sticking to your trading plan.
The last way to fight against recency bias is to know yourself and be self-aware at all times while trading or analyzing the market. You can think of trading as the most intense mental ‘game’ you’ll ever play, and winning the game takes a strong sense of self and self-awareness. It’s all too easy to get caught up having a recency bias as a trader, and not even realize you have it. You need to constantly monitor your trading mindset and your actions and make sure you’re acting on logic and objectivity, not emotion. You can help yourself do this by keeping a trading journal and sticking to your trading plan as we discussed above.
All trading errors are a result of acting on emotion instead of logical decision-making based on fact and objectivity. Recency bias is no different; you are letting your most recent trading results influence your decision making too much, basically due to the emotions that you feel following those trades. I’ll admit, it’s relatively easy to diagnose these issues, but it’s much more difficult to identify them in ‘real-time’ and stop yourself from committing them.
It takes effort, but you can overcome recency bias and other trading mistakes if you focus enough and trade with discipline. This means you have to make a conscious effort to overcome them, because left to our own natural tendencies, we humans are simply not wired to trade properly. Following the tips I discussed in today’s lesson will definitely help you focus on the bigger picture in your trading and help you eliminate the tendency to let your most recent trading results over-influence your next trading decision.
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- Warren Buffett
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