It’s official… and brutally scary.
Scientists have confirmed what we already suspected…
Our human brains are our own worst enemy when it comes to investing or trading.
You see, nearly all traders (professional and non-professional) make the same costly psychological mistake.
I shall reveal to you in this article what the deadly mistake is and how you can learn from it…
Scientists who study the human brain have reported that investors and traders twist historical data so that they see exactly what they want to see: low risk and big returns.
According to scientific studies published in MarketWatch:
“When you want to believe something, you’ll do what is necessary to convince yourself that it’s true. Like ignoring historical [market] data that gets in the way.”
Psychologists call this “confirmation bias” – or by its more fancy term: cognitive dissonance.
We human beings are programmed to avoid pain. Confirmation bias is therefore our natural human instinct to avoid information that is painful.
And it is not just the ordinary public that make this mistake. Professional traders in Wall Street also frequently do this too.
Both professional and non-professional traders dismiss facts, block reality, deny history, crashes and meltdowns.
A good example of this was during the 2008 stock market crash. Many “bullish” investors in Wall Street refused to accept that we were at the start of a major bear market.
In 2009, the exact opposite happened. People were so scared of stocks that they ignored the initial signs of a bull market.
Again, we see what we want to see. Confirmation bias makes fools of otherwise very intelligent and smart individuals.
So how can we fight this human instinct which causes us to make terrible and costly investment and trading decisions?
The answer: do the opposite of what comes to you naturally.
Instead of looking for information that confirms your views about the market, do the opposite: look for information that negates or disproves your opinion.
Make no mistake. This will NOT be easy.
Nobody likes to admit that they are wrong. Think of how many people you know that freely admit to you that they are wrong. I can probably think of two – not many.
The majority of people like to think that they are always right. And guess what? That instinct is exactly what makes them bad investors.
As good investors and traders, we need to think differently from other people.
Here is a recent example of how we fought our natural instinct for confirmation bias. Take a look at this chart:
As you can see, in early December gold broke above its downtrend line. In technical anlsysis, this usually indicates that the downward trend in gold had likely ended, and we are about to start a new upward trend.
However, something wasn’t right…
I am a great believer in fundamental analysis. Fundamental analysis told us that you cannot look at the chart of gold and ignore the chart of the US Dollar. This is because gold and the dollar are inversely correlated.
The chart of the US Dollar showed NO sign or evidence of a change in trend. If gold had truly reversed its trend, we should have seen some evidence of this in the US Dollar – such as a break below its uptrend line.
Now consider this for a second…
A trader who is “bullish” on gold, may have interpreted the gold chart in such a way to CONFIRM his own belief that gold will go higher. He would see what he wanted to see.
But as good traders, we looked for market information to disprove or falsify our own beliefs. The chart of the US Dollar disproved our theory that gold was about to start a new upward trend.
And we were right.
Soon afterwards gold reversed and dropped below its downtrend line again – showing that it had no intention to go any higher. In other words, it was a “false breakout”.
This is an example of how we can conquer our human brain’s instinctive and dangerous pattern of making bad investment decisions.
By learning to avoid psychological mistakes, we can increase our win ratio and have more confidence in our trading.
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