Outcome Bias in Trading: A major obstacle to profitable trading
Does ‘the end justify the means’ if we scored big in a trade as a (Day) Trader?
I would strongly argue NO and go even further: “Dumb luck” is one of the most dangerous things that can happen to us in Trading!
Why? The reason to this can be explained with one of the most prominent behavioral biases, the Outcome Bias or also called “disparity fallacy” or “equity fallacy”.
To fully understand this and the toxic effect on our trading performance, let’s break it down step-by-step:
First, let’s understand what is the Outcome Bias.
Second, analyze how it can effect our trading decisions with some examples,
and third, discuss what we can do as trader to countermeasure the effect and build a system of better trading decisions.
If you are interested in trading psychology and common behavioral biases which explain a large extent of our oftentimes destructive trading behavior, feel invited to also check other articles I wrote on the Gambler’s Fallacy, the Blind Spot Bias, the Pessimism Bias, or also Daniel Kahneman’s Prospect Theory.
- What is the Outcome Bias?
To put it simple: The behavior of judging the quality of a decision only based on its outcome is what we call the Outcome Bias.
We can witness the Outcome Bias in nearly all aspects of life, whether it is in medicine, sports, at work, gambling, or trading.
When looking at other people, we have limited visibility on their decision making process, whether that decision was actually good or bad. Consider a heart surgeon who decides to perform a risky surgery, however sadly the patient dies during the surgery. It is easy to judge the surgeon’s decision as bad, but what do we know about the background, the probabilities of success if doing the surgery vs. when not? It might be that a highly unlikely event happened during the surgery, and that the overall decision to perform the surgery was indeed the best decision at this moment.
What effect might this behavioral bias have though? To better understand it, and which type of the judgements are actually critical and dangerous, let’s have a look at the following process outcome matrix.
A “good” process would refer to a rational decision based on probabilities, choosing the decision which provides a favorable risk reward outcome. On the other hand, a “bad” decision refers to a decision which does not weigh the probabilities of success.
The two dangerous combinations, especially for trading, in this matrix are “dumb luck”, so having a bad decision process, however still receiving a good outcome, and “bad break”, so having a good decision process however receiving a bad outcome. Before deep-diving into this, let’s first understand a bit more how easy we are to misjudge due to the outcome bias and how common it happens.
Annie Duke gave a great example for this in her book “Thinking in bets” for poker players. Poker is a very good example as playing your hand is mostly based on probabilities with an unknown outcome at the time of decision making. We have a great poker player that strategically weighs the decisions based on the probabilities, competing against a player who does not. Consider it as the “good” decision making process vs. the “bad” decision making process in the matrix. Now if those two players compete for 8 hours, the likelihood of the good player losing is still over 40%, even though he/she did all the good decisions.
As viewers of the poker match, we only see those snapshot of 8 hours and see the “bad” player winning, we are very likely to think the bad player is actually good and vice versa.
Of course, assuming unlimited capital and a long enough playing time, the chances of the “good” player to win would approach 100%, however in reality we barely have those kind of situations.
So far, we have discussed the Outcome Bias in situations in which we observe other people’s decisions, however the Outcome Bias is not limited to this. We might follow, trust, bet on, or take advise from the wrong people, but it is oftentimes even more destructive judging our own decisions when being victim to the Outcome Bias. Why? Let’s apply the Outcome Bias to Trading and see what effect it may have on ourselves and our performance.
2. Outcome Bias in Trading
Having understood the Outcome Bias, let’s have a look at 2 common trading examples which I am sure many of you have already experienced in a similar form yourself. Many of our trading decisions can actually be explained by the human behavioral tendencies we’ve discussed so far.
In the first example, we have a trade which initially shows little price action until it is hit by bad news. As the price drops from bad news, the trader is not willing to give up on the position, but decides to double-down on the trade, entering a second position. After entering the second trade, the price starts to increase and runs in the initial take-profit level, leaving the trader with a nice profit. Excited from the great trade outcome, the trader might conclude that he or she is great at news trading, stoked to have found an apparently effective trading strategy of trading the bounce-back from a strong price action due to news.
However, what has happened here? The trader experienced a “dumb luck” situation as defined earlier in the process outcome matrix. Based on the trading system, the trader should have cut the losses, but instead doubled-down on the trade. Moreover, the trader this time got lucky, creating a “good” outcome. A situation like this can easily lead the trader to think of having found a new profitable trading strategy, and the recent success “justifies” an adjustment of his current strategy. Little do we know whether the previous strategy was profitable, or whether the new trading strategy will be profitable, deciding on this would require much more data on a longer timeframe. However, traders receptive to the Outcome Bias will not focus on the decision process, but the outcome, and in the given situation the outcome gives a clear direction.
The situation could be very different though. Consider this second example:
The trader opens and then closes a trade in profit based on his or her trading strategy. After closing the trade, the trader witnesses how the price keeps and keeps increasing, creating a feeling of having “lost” this additional profit that could have been made in the trade. After a while, the trader decides to re-enter the position seeing all this forgone additional profit.
Shortly after, the price reverses, giving a loss in the second trade, completely offsetting the initial profit with the first trade. Therefore, the trader starts to question whether any of his or her decisions are actually correct and decides to double-down, hoping to recover at least the initial profit. The price keeps dropping though, leaving the trader with a big overall loss and full desperation.
Again, what has happened here? This time, we could describe the situation has having a “bad break” for our decision outcome matrix. The trader even made a profit, and also the second trade entry may have been according to the trading system. An unfortunate development of the trade associated with a lot of pain led the trader to doubt the own system though, deciding to try saving the trade by doubling-down. Again, seeing how the first trade could have made much more profit and seeing an initial loss in the re-entry “justifies” the decision for the trader to change the current system as apparently the current system gives only losses. The initial system might be profitable, however due to some bad luck (which statistically is meant to happen all the time in trading), the trader deviates from it.
Based on the two examples, we can conclude that being receptive to the Outcome Bias in Trading will lead to constant doubt about the own strategy and skills, as we associate a bad trade outcome with a bad process, and a good trade outcome with a good process. Moreover, if the trader deviates from the current trading strategy due to the doubt or excitement from bad takes and dumb lucks, the trader is likely to apply a much more emotion-based decision approach, disregarding the inputs set by the trading strategy, and consequently due to the missing guardrails rather applying emotions as action triggers. Trading based on emotions will open ourselves up to many more behavioral biases with even more destructive results. Lastly, concluding from dumb luck trades to apply a different strategy strongly increases the likelihood to follow strategies that are actually not profitable, thereby entering a doom loop of constant adjustments, confusion, pain, and ultimately most likely a margin call.
However, of course there are things we as traders can do to prevent or soften the impact of the Outcome Bias on our trading. Let’s discuss those in part 3:
3. Countermeasures to the Outcome Bias
Before deep-diving in 3 countermeasures we can apply as traders, let’s summarize in very short what we have to keep in mind as traders when dealing with the Outcome Bias.
a) A good trade does not necessarily have a good trading outcome!
b) A good trade outcome does not necessarily mean we traded good!
As a result, it becomes very clear that as traders we should detach our trading results from our trading strategy in the short term. Looking at single trade results has little to no correlation to how good or bad our trading strategy is. However, we are all human beings and it is very difficult to detach those two as we are wired to do so. Therefore, we need dedicated countermeasures to do so. The following three have shown to be effective for us and other traders we know:
1) Situational Awareness, 2) Rigorous tracking & analytics, 3) Reducing complexity during trading. Let’s go step-by-step what those are:
Situational Awareness:
If you’ve read our previous articles on different behavioral biases and traders’ countermeasures, you will be familiar with Situational Awareness already. By its nature, behavioral biases are unconscious, therefore we do not recognize their effect on our behavior until we are aware of them. By reading this article, you have done the first step necessary to start recognizing when you become victim to the Outcome Bias, thereby moving this bias from unconscious to conscious. You understand the bias, and the next time you think whether you should adjust your trading strategy, you may think about the Outcome Bias and challenge yourself whether the process leading to your decision was bad or good. This is the necessary foundation for every trader out there. Adjusting trading behaviors is never an instant process, it always starts with understanding, recognizing, and then step-by-step adjustments.
Rigorous tracking & analytics:
The very best counterargument against constantly adjusting our trading system and behavior is if we can see black and white what actually works for us and what doesn’t. Before the advancements in tools, we were rigorously tracking every single trade of ours manually (in Excel or even on paper), identifying behaviors, listing our motivations and emotions during the trade, and try to match this with market indicators, volumes, or price levels. Luckily, nowadays we have automated trading journals and even more advanced behavioral analytics software. All of our trading actions will be automatically tracked, analyzed, and we just have to check which strategies and behaviors are actually profit- or loss-making for us.
As traders, we can easily deviate from our strategy if we are in doubt. However, seeing our decisions and outcomes based on hundreds of trades, how we would perform if closing our position slightly earlier or later…
… doubling-down on trades that are already in loss…
…or how we perform trading with or against the market trend…
…can give us as traders the necessary long-term viewpoint required to gain the confidence in our trading strategy, and thereby easily identify a “bad break” trade if they happen.
Of course, every beginning is hard, and we need this large enough data set of historical trades in order to find those significances and gain this confidence. If we do not have this yet, we can either keep trading on a demo account or trade with such small position sizes, that we prevent strong emotions from overtaking the lead on our trading decisions.
hoc-trade is one of the tools which can be used for your tracking and analytics, and it actually tracks and analyses many more behaviors compared to what is shown here. If you would like to have a free testing access to the beta version, feel invited to join the Discord server, you’ll get all accesses there.
Reducing complexity during trading:
During trading, our brain processes a huge amount of data and new information, every new tick of price quotes, news, analyses, our emotions, and more. Naturally, we do not have much time during trading to make decisions, which fuels ourselves to work in ways that are naturally wired in our brain. As you can imagine, one example of this is the Outcome Bias. If we only have a very short time to make decisions, we may not account for the process, but use the shortcut to only look at the outcome. In order to give ourselves more time to make decisions, we should limit the complexity during trading as much as possible. This may include the amount of positions we enter at the same time, the amounts of trading symbols we are following, the number of news websites tracking, the social media running, or whatever else takes some of your focus. If we really want to build a successful trading system, we can focus on one asset only, during a specific time of the day, repeating our strategy over and over again. By doing so, we give ourself the chance to build confidence and the data set required to judge its effectiveness. If our strategy and approach are proving to be effective, we can slowly start to scale and thereby also increase complexity.
Summary
Working on behavioral biases is not an easy task, and most of the traders in the market will never do so due to its complexity and unconscious nature. At the same time, most of the traders are also losing in the market.
The moment we accept that we, just like everyone else, may act based on known behavioral biases, we can start working in them. For the Outcome Bias, we first need to recognize the moments in which we judge decisions purely based on its outcome. We build a solid database of our decisions and outcomes, thereby creating a reference point which we can confidently draw from. Lastly, we try to reduce the complexity in our trading as much as possible, to give ourselves and our brain to most possible time to process information and do not act in pre-wired behavioral structures.
Thank you very much for reading, happy trading, and stay safe!
