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Can our Trading Decisions ever be Free from Bias?

The notion of achieving a state of judgment entirely free from bias seems quite improbable given the inherent workings of human cognition. But there is good news...

 

Kahneman was awarded the Nobel Prize in Economic Sciences for his work in integrating psychological research into economic science, especially concerning human judgment and decision-making under uncertainty​


Daniel Kahneman, a Nobel laureate in Economics, and author of 'Thinking Fast and Slow', delves deeply into various cognitive biases and heuristics that affect our thinking and decision-making.


Kahneman identifies a number of cognitive biases in his book, including:

  • Confirmation bias: The tendency to seek out and interpret information in a way that confirms our existing beliefs.

  • Availability bias: The tendency to overestimate the importance of information that is readily available to us.

  • Representativeness heuristic: The tendency to judge the likelihood of something happening based on how similar it is to something else that we know.

  • Anchoring bias: The tendency to rely too heavily on the first piece of information that we receive when making a decision.

  • Overconfidence bias: The tendency to overestimate our own knowledge and abilities.

These biases can affect our thinking in a variety of ways. For example, confirmation bias can lead us to ignore or discount information that contradicts our beliefs. Availability bias can lead us to overestimate the risk of rare events, such as plane crashes. Representativeness heuristic can lead us to make bad investment decisions. Anchoring bias can lead us to pay too much for a product or service. And overconfidence bias can lead us to make risky decisions without fully understanding the consequences.


Kahneman argues that it is important to be aware of our cognitive biases so that we can try to avoid them. We can do this by slowing down our thinking and carefully considering all of the available information before making a decision. We can also seek out feedback from others and be open to the possibility that we may be wrong.


Educational and Structural Interventions: Kahneman suggests that while individual judgments are prone to bias, certain educational and structural interventions can help mitigate biases. For example, learning about statistical thinking, promoting a culture of critical evaluation in organizations, and using algorithms in decision-making can reduce some impacts of biases.


Is Bias inherent in our nature?

Kahneman explains that human thinking is governed by two systems. System 1 is automatic, fast, and often subconscious, while System 2 is slower, more deliberative, and logical. Biases predominantly arise from System 1's rapid, heuristic-driven responses. While System 2 can theoretically override these biases, it often endorses the suggestions of System 1 without sufficient scrutiny. This dynamic leads to overconfidence bias.


Overconfidence Bias

Overconfidence bias is the tendency to overestimate our own knowledge, abilities, and judgment. It is one of the most common and pervasive cognitive biases. There are a number of reasons why we are prone to overconfidence bias. One reason is that we are generally better at remembering our successes than our failures. This is known as the availability heuristic. Another reason is that we tend to focus on our own strengths and ignore our weaknesses. This is known as the illusion of superiority.


Another example of overconfidence bias is the illusion of understanding. When we make a decision, we often have a false sense of confidence that we understand the situation and that we have made the best possible decision. This can lead us to make bad decisions, even when we have access to good information.


Mitigating Bias in our Decision making

Kahneman advocates for education in statistical and probabilistic thinking. This type of education can help people understand concepts such as regression to the mean, the law of large numbers, and the role of chance in outcomes. By understanding these principles, individuals may be better equipped to recognize when their intuitive judgments are leading them astray.


Where possible, Kahneman recommends using algorithms in decision-making processes. Algorithms, when well-designed, are not subject to the same biases as human judgment. They can process large amounts of data consistently and objectively, reducing the influence of subjective bias.


Conclusion

While Kahneman highlights the challenges in completely freeing judgment from bias, he also suggests ways to mitigate bias through education, awareness, and structural changes in decision-making processes. However, the notion of achieving a state of judgment entirely free from bias seems quite improbable given the inherent workings of human cognition as described in his book.

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