Recency Bias: How It Affects Your Trading

Follow us on LinkedIn

Trading is a difficult endeavor, and the main reason most traders fail is that they don’t have an edge. The expectation value of most trading strategies is zero before commissions and slippage. Taking commissions and slippage into account, trading is a negative-sum game.

Even with a positive expectancy trading system, the random nature of the market will likely make traders abandon their good system. Let’s say, for example, you have a good trading system with a winning rate of 60% and an overall positive expectancy. This means that 40% of your trades will be losers. Suppose that you start trading this system, and your first 4 trades turn out to be losers. Human psychological bias will make you conclude that the system is bad, and therefore you stop trading it.

In behavioral finance, this psychological bias is called recency bias. It affects us more often than most of us can imagine. Let’s go through a concrete example of a fictional trader called John.

  • Trader John developed or learned about a good trading system, but he stopped trading it after 2 losses in a row.
  • Frustrated, he tried a system he learned from a guru on YouTube, and it worked great a couple of times in a row.
  • John started believing that he had found the holy grail and started increasing size.
  • The market went against him and he experienced a loss.
  • John decided to hold on to the loser because his strategy has 90% probability of success, and he thought that the losers would eventually become winners.
  • Another unfavorable move in the market created a massive “paper” loss in his account.
  • The next day, he received a phone call from his broker asking him to deposit more money to cover the margin. He didn’t have enough money, so the broker liquidated the position and his account was wiped out. John lost almost all of his trading capital.

Does this story sound familiar?

As we can see, recency bias affects our trading in a negative way. The key to profitable trading is to develop a robust, positive expectancy system, have confidence in it, and stick with it, especially through bad times.

Further questions

What's your question? Ask it in the discussion forum

Have an answer to the questions below? Post it here or in the forum

LATEST NEWSGuoquan: Continuously Expanding the Business Scale While Enhancing Profitability
Guoquan: Continuously Expanding the Business Scale While Enhancing Profitability
Stay up-to-date with the latest news - click here
LATEST NEWSMusk's Grok-1.5 AI chatbot to be available next week
Musk's Grok-1.5 AI chatbot to be available next week
Stay up-to-date with the latest news - click here
LATEST NEWSJapan finally screens 'Oppenheimer', with trigger warnings, unease in Hiroshima
Japan finally screens 'Oppenheimer', with trigger warnings, unease in Hiroshima
Stay up-to-date with the latest news - click here
LATEST NEWSFirstFT: Obama and Clinton back Biden’s support for Israel’s war in Gaza
FirstFT: Obama and Clinton back Biden’s support for Israel’s war in Gaza

Also in today’s newsletter, OpenAI courts Hollywood and Easter egg shrinkflation

Stay up-to-date with the latest news - click here
LATEST NEWSUkraine receives $1.5 billion funding tranche under World Bank programme, says PM
Ukraine receives $1.5 billion funding tranche under World Bank programme, says PM
Stay up-to-date with the latest news - click here

Leave a Reply