Don’t Let The “Endowment Effect” Affect Your Trading Performance


 Having a bias is as natural as breathing and eating. Personal judgments – reasonable or not – are entrenched in our everyday activities.

You use your biases, for example, to pick a restaurant, a potential date, or the school you want to place your child in.

In trading, you use your biases to find trade opportunities. You might have read a headline or heard a rumor and decide to look for evidence to support your hypothesis. Add to that a favorable technical setup and presto! A trade idea!

Being confident in your biases is also important in risk management. After all, it takes a certain level of confidence to stick to the plan when the market isn’t playing out your best-case scenario.

While there’s nothing wrong with using your biases to look for setups, though, irrationally sticking to them could spell trouble for your trades.

In the early 1970s, economist Richard Thaler introduced the idea of the “Endowment Effect,” which describes our tendency to place higher value on the things that we own.

A popular study found that a group of college students who were given mugs (so that they owned them) placed a higher value on their mugs than another group who were asked to price them.

Researchers believe that this is partly due to the fact that, once owned, foregoing something you own feels like a loss and humans are in general, loss-averse creatures.

The Endowment Effect tendency can also include biases or opinions as we tend to place a higher value on our opinions because we own them. Mary, for example, gets into heated political debates on Facebook while her friend Mark tends to favor his own ideas in business meetings.

The difference between having an opinion on a business decision or a political inclination and a trade is that there ARE right and wrong answers in trading.

For traders, the market is the judge, the jury, and the boss. Placing an order on the back of a hypothesis, no matter how convincing, does not guarantee that the price action will go your way.

This is why it’s important to be flexible with your trade biases.

Unless you’re prepared for ALL the scenarios that could happen to your trade, you must always be ready to make the necessary adjustments to protect your profits. What’s a couple of wrong initial trade ideas if it means living to trade another day?

If you’re not used to the habit of changing your biases, then here are a couple of exercises you can do:

1. Approach your trade idea from different angles.

You can start by being more thorough with your research.

It’s easier to give more weight to articles that support your biases, but it’s more profitable in the long run if you also consider information that could tip the scales against your trades.

2. Re-examine your biases regularly.

Planning trades doesn’t end with placing orders. Once they are triggered, it’s your job to keep an eye out for scenarios that you might have missed in your pre-trading preparations.

This is especially true in the forex markets where market drivers can shift very quickly and very often. Read news updates, double check your charts, and talk to traders who have different opinions.

After every significant event you must ask yourself: “Does this invalidate my original trade idea?” If your answer is yes, then it’s time to make adjustments. Otherwise, you’re just gambling (or praying), not trading.

3. Use a trading journal.

The most effective way to practice trading flexibility is to use a trading journal.

Logging in your trading processes can give you valuable insights such as where you usually get your research, how you react to catalysts that invalidate your trade idea, and how much you usually gain or lose when you fail to be flexible with your biases.

Having biases is not the death knell of forex trades. In fact, it’s a good way to start looking for a trade idea. Just don’t expect your opinion to be the only option for the markets.

It’s the habit of sticking to a bias despite contradictory evidence from price action or fundamental themes that can slowly weigh on your trading account.

Don’t forget that, when it comes to the markets, you have to trade what you see and not what you think the markets should be doing.