First of all, we find patterns in noise. The stock market is primarily just financial noise data, completely random and only punctuated by periods of psychology based trading or algorithms that are mirroring psychology based trading. We need to be conscious of these issues so that we can mitigate the risk that comes along with them and allow ourselves to make good quality trades based on good data.
And while all, while being aware of the potential weaknesses that we have, because we are flawed human beings and we make mistakes. So let’s talk about some of these issues that I see happening time and time again with patterns. And the first of those is that people find patterns where none exist.
Dangers of Over Analysis
One of the biggest dangers when it comes to Technical Analysis is over analysis. You’re going to focus on things that really match your own bias, your own goals, and in turn. You’re going to make decisions based on coincidence and probably find patterns where none exist. Another issue that we have with patterns in particular is that we expect history to repeat itself.
It’s visceral and we rely upon that information and we tend to forget about things that have happened in the past. We focus on the now and that the now matches our. Bias in it matches the decisions that we’re making based on coincidence and maybe even matches these patterns that don’t exist. If all of these things work in tandem, it can result in us making a lot of bad trading decisions, uh, that we could have otherwise avoided if we were conscious of our different types of biases.
And it’s these brief moments that we can capitalize on through Technical Analysis. So we tend to find patterns and noise. We find patterns where none exist.
The Bandwagon Effect
Eventually you end up with a group of individuals that all are sharing the same idea. They’re talking about it, they’re positive, they’re excited, and it makes its way back to you and your little idea. That seed of a concept that you have is now being reinforced by the countless millions of faces online.
You were going to jump into what’s called the bandwagon effect. You have made everyone excited. They’re making everyone excited in this positivity feedback loop that we mentioned earlier in the course. Another thing we need to be conscious of is the confirmation bias. You’re going to be looking for things that match what you expect to happen.
If you think the Tesla is going to move to the upside, you will focus on finding indicators and elements and people who confirm what you already suspect to be true. You will ignore a contrary indicators. You will ignore people who are nay-saying and you will focus primarily on what you believe is going to happen.
It’s a confirmation bias. Another bias we need to be conscious of is the hindsight bias. The hindsight bias basically has you looking at historical events and then using that information to look at your own current event and saying, yeah, I knew exactly what was going to happen. All of these other times I knew what was going to happen this time I knew it was going to happen next time.
Hindsight is 20/20
We are simply reacting to conditions that are present. I have no idea what it’s going to happen moment to moment. All I can do is wait for that data to come to me, make a rational decision based on the information I have provided and hope that I am making it in the right direction and knowing that if I make a mistake, I’ve already established a plan to mitigate my risk and my loss and I’ll move on to the next trade.
That’s what Technical Analysis does for us. The last thing we want to talk about is the positivity effect. And this really means that we are going to be confirming and focusing on things that have happened to us that are good. If you are excited about five, both legs that have broken to the upside for you and you are going to ignore 20 that have failed, that’s the positivity effect.
Be aware of Cognitive Bias
We remember the good times we ignore or press the bad times and eventually all we end up with is a situation where you’re feeling good. You believe you’ve known all along that both legs break to the upside. All the indicators seem to match what you’re thinking. Everyone else is saying, yes, this is a good trade, and you’ve already found this pattern that may not necessarily exist.
All of these things work together, work in tandem, and they get us excited about a potential mistake. So when we’re trading patterns, we need to be aware that all this happens all the time, and we need to be conscious of the fact that humans are flawed creatures. We can use technical analysis, but ultimately it relies on us being aware of ourselves and making decisions while being conscious of our flaws.