the psychology of successful trading

Omission Bias and Financial Markets

What Is Omission Bias?

Omission Bias is the tendency to think it is better to do nothing than to do something and make a mistake. We all have this tendency because it is a fundamental part of our psychology. It can be particularly strong when thinking about how much we will regret something in future if we make a mistake. We think we will regret doing nothing less than we will regret doing something.

This matters in financial markets, because it is not necessarily better to do nothing than to do something. The tendency to inaction creates inertia. We hold on to stocks longer than we should. We fail to buy new stocks when we should also do that. Formally, this is because is no practical difference between the following two scenarios. I could invest $100 in a stock that declines 10% the next day. I could also fail to buy one stock that appreciates 10% the next day. In both scenarios, I have lost $10. But Omission Bias will make me think that scenario two is better than scenario one. This is because in scenario two I have done nothing while in scenario one I have done something.

In this way, our psychology makes us prefer to do nothing. But the only important metric to judge the quality of my trading is the financial result. And that was the same in both scenarios: I do not have $10 that I would have had.

Adverse Effects of Omission Bias

A major adverse effect of Omission Bias is that it impairs your ability to assess performance. You will only look at what you did as opposed to what you did not do. This is because you are only worried about things you did that did not work. You don’t worry about things you didn’t do that would have worked because Omission Bias takes out the regret in that second case.

But the only measure of importance is how much money you made as compared to how much you could have made. So there should be equal attention paid to opportunities missed as there is to opportunities taken which did not work out.

This adverse effect is of crucial importance.  Many investors do not have clear enough data of what has worked for them and what has not.  It is essential to have a good focus on this for a number of reasons.  

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One benefit is that you can only manage your portfolio appropriately if you have been examining its performance precisely.  A second benefit is that you might be able to identify some specific sorts of trade that you are particularly good at.  You can then seek to identify relevantly similar situations and exploit them.  Also — you might have a chance of avoiding disasters from the past occurring again!

Our ability to look at our failures and learn from them is also impeded by our natural distaste for thinking about the unpleasant — but failures are always more instructive than successes.  One might almost say that any fool can succeed — but only an expert can fail well…

Practical Consequences

A major practical impediment to any attempts to correct for Omission Bias is due to the sheer scale of the problem.  The number of shares you did not buy yesterday is absolutely huge.  There is no way you can think about all of those.  Nor should you.  The more useful comparison is to think about the shares you could have bought or the ones you almost did buy.  So that tells us that you should be looking at several buy options at a time.  Look at what factors led you to choose the one you did choose.  

Maybe you were looking at three oil companies.  You compared them on price/earnings ratios, dividends and price/book value.  You made a choice.  Did that work out?  (Don’t do this next day.  Wait for a reasonable period.  Otherwise you will just be looking at noise.)

Omission Bias is a sort of Agency Effect

What fundamentally is going on with Omission Bias is a sort of agency effect.  If something bad happens and you could have prevented it but did not, this is seen as morally less culpable than if you did something which caused a bad outcome.  After all, “you didn’t do anything.”  I think this perception might be strengthened by the fact that the law says a lot about what we cannot do but rarely says anything about what you must do.  You are at liberty to walk past a baby drowning in a pond.  You are not at liberty to throw a baby in a pond.

This might be fine morally.  But stock markets are not outlets for moral action.  They are locations where you can profit.  Or not.  Bear in mind the possibilities of Omission Bias affecting your judgements of your own decision-making and your decisions will get better and more profitable.

Learn more in the video below: