You Should Manage Optimism/Pessimism Bias in Trading

Psychology is an important concept in day trading and investing. In the past centuries, some of the best-known investors and traders have failed simply because of not managing their psychology well.

For example, the collapse of Long-Term Capital Management (LTCM) was mostly caused by psychological reasons.

In the past, we have looked at the concept of overconfidence bias, anchoring bias and recency bias because we feel those are psychological aspects that need to be known.

In this article, we will look at the concept of optimism and pessimism bias and how it can affect a person’s trading outcome.

What is Optimism bias?

Optimism is defined as being hopeful and confident about the future of something or a situation. As such, optimism bias is defined as a situation where one believes that they have fewer risks of experiencing difficult situations or bad outcomes.

This cognitive situation is caused by several factors like their environment, their upbringing, and their past successes.

Optimism bias is often confused with overconfidence bias. People who are overconfident tend to be highly optimistic. However, the two are slightly different.

For example, people with overconfidence bias tends to base it on their expertise. For example, people with many years of experience in an industry tends to believe that they can make minimal mistakes.

A good example of optimism bias is what happened during the Covid-19 pandemic. At the time, some people with this bias believed that they could not get infected with the virus. Most of these people then avoided taking the vaccine.

What is pessimism bias?

Pessimism is the exact opposite of optimism. It is defined as a situation where you are less hopeful about the future. Pessimists tend to be negative about several situations.

In most cases, pessimism bias tends to overestimate the likelihood of negative events compared with positive ones. Being a pessimist has several implications, including failing to take risks and even depression.

Impact of optimism bias in day trading

Ignoring risk factors

There are several impacts that optimism bias has on day traders. First, optimism bias leads to the underestimation of risks in the market or in a strategy.

When you are highly optimistic, you tend to believe that the strategy will work out well. As such, you will often fail to do basic risk management strategies like having a stop-loss, failure to position your trades well and to use excessive leverage.

Overtrading

Second, optimism bias can push a trader to trade excessively. This happens when one opens too many trades per day, expecting that each of them will be profitable.

In most cases, overtrading is one of the riskiest things that one can do. It often leads to substantial losses since a trader is usually not doing too much analysis.

Overestimating returns

The other key risk of optimism bias is that traders tend to overestimate their current and expected returns. In most cases, when you are highly confident, you will often believe that the expected returns in your account will be higher.

As a result, this can lead to being overconfident, which could lead to substantial losses in the future.

Ignoring contradicting views

Further, optimism bias can push people to ignore any views that contradict their views. For example, if you strongly believe that a stock will rise, you will buy it even when there are signs that it will drop. A good example of this is what happens in a bull market.

In such a market, people with an optimism bias will often buy newly listed companies even when they have weak fundamentals. We saw this during the dot com bubble and during the Covid-19 bubble.

Poor returns

The most important consequence of optimism bias is that it leads to poor returns for a trader. When you are highly optimistic and confident, chances are that you will make simple mistakes when trading or even when investing.

Ignoring in-depth analysis

All this can be summed up as ignoring in-depth analysis before opening a trade or an investment. When you are optimistic, you will often ignore key facts when opening a trade. As such, this could lead to more losses.

Related » Wise Traders Should Believe in Analysis, not Forecasting

Impact of pessimism bias in day trading

Pessimism bias also has several important impacts in day trading. Some of the top impacts of pessimism bias in trading are:

• Closing trades too early - When you are highly pessimistic about the market, there is a possibility that you will close your trades too early. As such, you will often leave some profits at the table.
• Shorting bias - When you have a pessimism bias about a company, you will be biased to open short positions. Shorting is risker than buying because your maximum loss potential is infinite.
• Avoid opening trades - The other impact of pessimism bias is that you will often avoid opening trades fearing that you will make more losses.
• Waiting too long for confirmation.

Altered emotional state

In our introduction, we talked about some of the biases related to being too optimistic/pessimistic, but these two can affect our state of mind (and our emotions) in other ways as well.

The best example is the chance of becoming a victim of fear/greed, and we know how risky this state of mind can be for our account.

Here, trading with the fear of making a wrong play, or with the greed of generating lots of profits in a short time, is likely to lead you to huge losses.

You cannot overlook FOMO (fear of missing out) and availability bias here. In short, a bit of optimism and fear is healthy--too much can have unpleasant consequences!

Causes of optimism and pessimism bias

There are several causes of optimism and pessimism bias. First, your trading experience can lead to this bias. For example, if you have a long experience as a profitable trader, the impact is that you may have some optimism bias.

Second, social media can lead to this bias. If the people you follow are highly optimistic about the market, you will often be optimistic about an asset as well. Socia media hype can trigger this type of bias as we saw during the meme stock mania.

Finally, news of the day can lead to this bias. For example, when news is highly negative, it can lead to a pessimism bias that pushes you to short stocks.

How to recognize them and find a balance

All the above information we have given you seems to paint a catastrophic scenario, where we cannot flinch and keep our emotions in check all the times.

However, this is not possible, but neither is it necessary! All we have to do is find the right balance, and there are many opportunities to do so:

• Having a good risk/reward ratio is the basis for a balanced career.
• Create and maintain a trading routine (with some flexibility!).
• Have a trading plan to follow that reflects the needs of our daily goals
• Work in teams, especially in a trading office, to compare with other traders

Summary

We all have optimism and pessimism bias. Therefore, the right thing for you to do is identify your bias and then find the balance between the two.

Most importantly, you should focus on doing your own research about assets and then making informed decisions.

External useful resources

• Bullshift: How optimism bias threatens your investments and finances - Financial Post