More and more traders are reaching for charts these days, and that’s a good thing. Knowledge is a powerful tool if you use it wisely. However, if you let confirmation bias creep in, your technical analysis can hurt your portfolio.
Confirmation bias is defined as the tendency to interpret new evidence as confirmation of one’s existing beliefs or theories. The new evidence in this case is the chart. Analyzing the charts of stocks or indices is how you form a theory. It doesn’t work the other way around. Your goal is to interpret the charts and respond accordingly.
Don’t think veteran traders are immune to confirmation bias! We can be stubborn and believe we are right even if the technical condition says otherwise. I have seen a lot of traders being dragged, kicking and screaming, into believing the market was heading higher from those dark days last December. I was one of them! But then I studied the charts and said, “Enough is enough. The trend and momentum are up – it’s time to go with it or suffer a devastating fate.”
Confirmation bias is sneaky
Let’s say you have short positions or are long puts and are worried you’re on the wrong side of the fence. It is so easy to let confirmation bias sneak in and view what you want to see happen rather than what really is happening. A chart is like a painting; it is open to individual interpretation. Two people can view the same chart and come away with diametrically opposed technical opinions. One of those people will be right.
Here’s why confirmation bias is so dangerous: It can cause you to lose – not make – money. If you ignore evidence that the trend is changing direction, you might not cut bait in time. You might stick with the position and go down with the ship. Remember: a small loss is better than a big one.
Even if it feels awful, pull the trigger and sell!
In the meantime, commit to studying technical analysis. There are so many patterns out there that you can easily get lost in the shuffle and make serious errors in judgment. Learn the patterns and what they mean for future action, and play accordingly.