1. Poor Decision Making www.fxrenew.com
Mental Bias
Answer Sheet

2. Question 1:
Review the following table of data and answer this question: What is the relationship between the people that believe there's no gain without pain?
Answer to question 1: It might appear that a positive correlation exists between pain and gain. Why? In judging the relationship, many people mistakenly overweight the positive-positive cases (pain/gain) relative to all other cases. As a result, they mistakenly conclude that the two events are positively correlated. In fact, in this example, a slight negative correlation exists. (47% of the people feel there's only gain with pain, whereas 53% of the people feel there's gain even without pain or pain even without gain).

3. This thinking is an example of illusory correlation, a type of confirmation bias in decision making. It's most evident in trading when traders search for information or interpret information in a way that supports their preconception, and can lead to a biased outcome. In the example above, considering the situations where the relationship between pain and gain does not exist is equally relevant to determining the correlation between the events. In other words: traders need to weigh both sides of a story, or try to understand what the opposing view is on any given trade.

4. Question 2:
Write down the last two digits of your social security number. Do you think the average temperature in Saskatoon, Saskatchewan, is higher or lower than this number, in degrees Fahrenheit? Now tell me what you believe the average annual temperature is in Saskatoon.

5. Answer to question 2: How does your answer to the second question relate to the first one? The two numbers are completely unrelated and the last two digits of your social security number should have no influence on your answer to the temperature in Sakatoon (which by the way is a long lost town in northern Canada). In tests, however, people's answers to the temperature question are positively correlated. Individuals with higher social security numbers submit higher estimates of the Saskatoon temperature. This is an example of anchoring, the error of assessing numbers (or probabilities) based upon a reference point (the anchor which is your social security number in our case), which overly influences ("anchors") the estimate.

6. This shortcut heuristic is helpful in many places, but can lead us astray when assessing value. It's the classic case of saying "GBP has dropped too much since before Brexit" (before Brexit being the anchor, which is nothing more than a price point, and has no absolute relevance to the fair value of the Pound at any given point in time). The solution? Do what market professionals do: stay in touch with fundamental drivers and chatter (available from bank sheets or market wraps) because the markets can press further than any logical computation would estimate. Furthermore, only by understanding the drivers and the sentiment behind a currency can you roughly estimate whether it has further to go or not.

7. Question 3:
You flip a coin ten times and the outcome is ten heads in a row. If the coin is fair, is the outcome of next flip more likely to be heads or tails?
Answer to question 3: For a fair coin, the answer should be that both outcomes are equally likely. Believing that the next flip is more likely to be tails because “tails is due to come up” is known as gambler’s fallacy, an example of availability bias.
In general, the availability bias occurs when our estimates of probabilities are influenced by what is most “recent or available” in our memories. Our memories are biased; the unusual result of 10 consecutive heads could influence our judgment of the likelihood of outcomes on the next flip.

8. As traders, we would all love to have a long string of winning trades
As traders, we would all love to have a long string of winning trades. Unfortunately, losses are part of the game and sometimes they make up more of our bottom line than we'd like. However, many newcomers fiddle with their trading strategies or become hesitant after only a couple of consecutive losses. Availability bias clouds their judgement and their capacity to say "this is to be expected, it's only a couple of losses out of the next 1000". This is the reason charts like this are important to keep in mind:

9. In a normal distribution, given a certain average win rate, it is entirely possible to have multiple losses in a row each month. One institutional trader whom I spoke to in the past, confessed having taken 29 consecutive losses in a row. He proceeded to tell the story of the fund owner, who would come to the office now & again...place a trade...lose a couple of million dollars. At that point, many on the trading floor wondered what he was doing! Until the day he sat down, entered a trade, and milked it for weeks on end, making three times his losses. The point is that availability bias is the thing that may hurt us most, in trading. We let our losses assume a higher significance than they deserve. Remember: you don't necessarily have to accept the losses. Just manage them correctly: keep them small, but don't structure your trading as an attempt to avoid them.