Get in the right mindset for trading.
The more you research into human cognition, the more questionable you become about what you take for granted. Features of your mind that you may have regarded as utterly rational, are demonstrated as huge cognitive blind spots that we're actually all afflicted with to some degree. Once you realise that your decision-making faculties, your ability to categorise incoming data, and even the veracity of your own memories can be compromised, it becomes clear just what a monumental project becoming a trader is.
Imagine not just having to contend with a masterful opponent in the form of the market itself, but also with a vast undefined region of unexamined cognitive biases and blind spots.
Suddenly your education as a trader begins to take a strange turn, and you begin to understand that excellence also requires an enormous amount of your own work. That's precisely what this trading psychology section is all about, bringing some of these blind spots to light and introducing you to them so that you begin to address how such a strange sunk Cost Fallacy can affect your trading.
Escalation of commitment, often referred to as the sunk cost fallacy, is one of the more detrimental cognitive blind spots that affect trading performance.
Essentially, the sunk cost fallacy and escalation of commitment refer to the way we increase our level of commitment to a prior choice, even when that choice was not the optimal course of action. Rather than seeing the cost of that choice as sunk (i.e money spent) we tend to continue to pursue a particular path in order to justify the earlier choice, rather than recognising it as a mistake and changing course.
We are vulnerable to this fallacy in all areas of our lives. You've surely had the experience of forcing yourself to finish a meal that you've paid for, even when you don't really want to eat any more or continuing to read a book when even after 200 pages you're not enjoying it.
'Vince paid $1000 to an indoor tennis club that entitled him to play once a week for the indoor season. After two months he had developed tennis elbow, which made playing painful. He continued to play in pain for three more months because he did not want to waste the membership fee. He only stopped playing when the pain became unbearable.'
(Misbehaving: The Making of Behavioural Economics, prof Richard H).
This perfectly demonstrates how a perceived loss can cause a person to act in a completely irrational way, which is far more detrimental in the long run than accepting the membership fee as a sunk cost and moving on. In all likelihood, as Thaler comments, if a friend had invited him to play tennis for free at a different tennis club he would have turned down the invitation, citing the injured elbow as the reason.
Chess is another particularly good example that takes us slightly closer to the world of trading. Imagine that during a game of chess you manage to gain an advantage over your opponent. You work to nurture that advantage, putting your opponent into an increasingly difficult position, but along the way you make an error of judgement and lose that advantage. Many players will still be so unconsciously committed to the old strategy, that they will fool themselves into thinking they still possess the advantage and keep playing in that manner, even though the situation on the board has changed.
Persisting with a reality that is no longer true could lead to a trader unconsciously missing opportunities that fit into a particular strategy. Eventually, this will cause them to make further mistakes, which will put them at an even greater disadvantage.
It's the same in trading. We often enter the market with a clear strategy in mind, then begin to ignore all the indications that suggest we may have made an error of judgement, sticking to our initial strategy as the market continues to move further and further out of our favour.
Sometimes a strategy may show initial signs of success, but then for whatever reason the market changes direction and being so married to our theories, we ignore the reversal and just wait for the price to go back in our favour.
Part of the reason for this irrational behaviour is that human beings feel perceived losses twice as intensely as perceived gains, which means we are almost programmed to ignore a trade that is rapidly spinning out of control in order to avoid closing it at a loss. We have no problem closing winning positions too early, because even if we have lost potential profits by doing so, our mental accounting allows us to score the trade as a win.
Another thing to keep in mind is that sunk costs are felt less over time. Thaler demonstrates this with an example from a study conducted by Gourville & Soman in regards to gym attendance, and found that it spikes just after members receive their bills and then gradually drops again as time passes and the cost of the membership is no longer so much of a concern.
So the bill comes in and you suddenly realise that you have to extract the worth, or utility, of the membership, so you start going to the gym again regularly, only to revert to your old lazy ways as time goes by and the money you paid starts to slip from your memory.
In other words, the longer you let your losses run, the more accustomed you become to the new situation and the closer you are to some sudden price move wiping out your account.
As with all the material in this trading psychology section, the aim is to get you thinking about the unconscious behaviours you exhibit while trading, in the hope that your awareness of them will lead you to reduce their effects. You may do so by setting strict stop loss and take profit levels or by having a rigorous plan before entering the market as well as the discipline not to deviate from it in the heat of the moment. Awareness of unconscious behaviours is the first step to correcting them.