Every trader and every investor possesses biases and behavioural scientists have classified entire dictionaries' worth. The most dangerous thing about these is they're often unconscious. Once a trader is aware of his biases, he can minimise the ill-effects.
Going through the self-examination required is a painstaking process. Unfortunately, the only way to do this or, at least, the only way I know, is to trade and make mistakes until you have a sufficiently large sample of data on your own methods. You must record the circumstances and thought processes backing each trade and log the mistakes you think you made. This will eventually help you invest or trade more efficiently, if you're honest and objective.
There are two broad categories of biases. One set is cognitive - the apparently logically beliefs you operate by. The other set is emotional - feelings that prevent logical action.
The commonest pair of the first set would probably be confirmation bias and the related bandwagon effect. Let's say you have an investment idea. For example, you think the rupee will continue to weaken against the dollar and, hence, exporters will receive windfall profits. This is logical and you'll find others who share your views. But if you only look at the research of those who agree with you, you learn little or nothing new. On the other hand, if you examine the opinions of those who disagree with you, you receive a fresh perspective, even if your views don't change.
Confirmation bias shows up often in other fields. Ideologically committed people tend to blank out data, research and opinion that contradicts their views. The bandwagon effect, or going with the crowd, usually follows from some confirmation bias. The trader looks for a confirmation of his view, he finds it and goes along with his buddies.
Think about it. There's a counter-party to every one of your trades. Presumably, that counter-party has a different view. The entity on the opposite side is right every time that you are wrong. It might be worth learning the counter-party's logic.
Assuming your logic is basically sound, you can live with confirmation biases and also make decent returns going with the crowd. But doing this automatically means some missed opportunities. Contrarian attitudes don't pay off most of the time.
But once in a while, being out-of-step offers huge returns. At the top of a bull market when everyone is bullish, or at the bottom of a bear market when everyone is bearish, the contrarian is the big winner.
Emotional biases are even more difficult to understand or control than cognitive ones. Loss aversion and the related disposition effect are perhaps the most common emotional biases. In logical terms, a gain of X amount is equivalent to a loss of X. But, although no trader or investor will dispute this, it is also true that the emotional distress caused by a loss of X is usually more intense than the elation caused by a gain of X. This leads to the disposition effect. Investors book profits too quickly for fear that these will disappear and turn into losses. They also hold on too long to losing positions because they hope against hope that the price will recover.
The most dangerous emotional bias is probably overconfidence. As mentioned earlier, most investors believe their profits are due to skill and the losses to bad luck. Actually, there is much luck involved in both and the best traders are aware of this. When you're lucky, look to maximise your gains; cut your losses when the luck is against you.
Successful trading and investment methods are designed to override common biases by creating mechanical rules. For example, a systematic investor who parks a fixed monthly sum automatically ignores short-term fluctuations. A trend-following trader who adheres to strict stop-losses automatically avoids disposition effects. Studying such methods can help to accelerate the learning process. But, ultimately, this is a battle against yourself.
