Confirmation bias and how to cope with it when trading Forex

Confirmation bias suggests that we fail to perceive our circumstances objectively. Instead we select the data that (in simple terms) makes us feel good, because it confirms our preconceptions and confirms our prejudices. With confirmation bias, which is also often referred to as "confirmatory bias", or "my-side bias", we'll search for, interpret, favor, and recall information that confirms our preexisting beliefs and theories. In many circumstances and situations we also dismiss all evidence, preferring to rely on our hunch, as opposed to hard data. This confirmation bias can lead us to make disastrous decisions involving trading. For example; we may cut winners too early, or stay in losing trades too long, as we become completely wedded to our views, despite evidence to the contrary.

Confirmation bias can be classed as wishful thinking, this leads to individual’s no longer gathering critical information in order to make a decision, they'll concentrate on the 'one side' of the information that supports the beliefs. The individual will instead only search for data that supports their irrational bias.

What do we believe in…

It would appear that we are evolutionary programmed to believe what we want to believe, and searching for any evidence to confirm our beliefs actually comes naturally. Counter intuitively it should feel more empowering for us to search for evidence that in fact contradicts our beliefs, this in turn could explain why opinions develop, survive and spread. Disconfirming instances, when many opinions are considered, argued (both for and against) and a consensus is arrived at, can provide a far more powerful method for establishing long lasting truth, as participants and debaters actively search for evidence to disprove a theory and thereby prove another.

An interesting exercise would be to set out your theories and then begin to actively look for evidence to prove your theories are wrong. For example; you have a trading strategy that you're convinced will work and you're interested in putting it to the test. So you begin to back test it, then forward test it, whilst forensically and suspiciously looking for any evidence that it may fail. After several weeks of testing, you mathematically prove beyond any doubt, that the method and trading strategy does in fact work. It's not infallible, but it has positive expectancy, if your money management and overall risk parameters are carefully maintained. In many ways you're replicating methods scientists would use in a lab, in order to arrive at the truth.

Danger of being wrapped up in confirmation bias

A hypothetical example of how we may become wrapped up in confirmation bias, eventually resulting in poor trading decisions, may take shape like this:

We're in a long swing trade in the EUR/USD, we've safely navigated a period of two weeks in the trade and have stayed long through a ranging period, then followed the developing trend to currently be up 75 pips. We've moved our original trailing stop of 150 pips up 75 pips, hence our risk is now 75 pips. We note that in today's economic calendar high impact listings, there's an ECB meeting scheduled at 12:30. The consensus is for no change, when the ECB announce their interest rate decision.

However, unexpectedly the ECB announce no interest rate change now, but indicate they're considering lowering certain rates in the short term and announce they're immediately increasing the amount of quantitative easing, above the current rate of €60b. €100b a month will now be made available for this accommodative, monetary easing policy, as they're concerned that inflation is stalling and the Eurozone economy is projecting negative growth in 12 months, unless they intervene now.

This dovish tone causes an immediate sell off in the euro, particularly the EUR/USD, the currency pair falls by circa 75 pips inside minutes, wiping out your profit. It then falls by 50 pips more and ends the day with you down 100 pips. The euro also fell versus all of its main peers. Despite all the evidence to the contrary, you remain wedded to your position, despite now nursing a loss and despite the sharp market sell off in the euro. You're now even considering widening your stop, as you still remain convinced the euro is strong and the dollar is weak.

This is a textbook example of how trading confirmation bias can harm our trading. Occasionally we'll see profits turned into losses, that's inevitable, however, we must never compromise our trading plan and never ignore the mountains of significant information that swims against the tide of our opinion.

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