CogBlog – A Cognitive Psychology Blog

A graph of $TSLA (Tesla Inc.) stock price going up.

I hope that you haven’t put all your life savings on $TSLA after seeing that juicy green graph. Hopefully, you won’t open the Robinhood app on your phone before reading this article. Even if you are one of the teenagers contributing to Robinhood’s 4.3 million daily average trades, I suggest you read this post before you go make another trade from your (or worse, your mom’s) life savings.

Here is a simple game for you. From what you can observe in the graph above, where do you think Tesla stock will go next. Would you buy some stocks? What about if you already had some Tesla stock. Would you hold, buy more, or sell? There is a lot of information missing from the graph, however, this type of graph remains the most important visual information that everyone sees first when. If you are a reader of this blog, you can probably guess that our primate brain isn’t as rational as we would like it to be!

If you said you would buy new stock or hold your existing shares in Tesla, you are out of luck. That above was one of the worst times to buy TSLA stock. It was the peak of a bubble (where prices rise without rationale), which would soon after pop (everyone realizes that the thing they bought is way too expensive compared to the actual value, and everyone starts selling). It turns out, stocks go up sometimes, and down in others. There is one direction they are sure to go at all times; sideways. That is until someone discovers time travel.

Are you feeling a little down because the financial game we just played didn’t pan out as you wished? Well, don’t worry. I showed you only a part of the whole story. That moment was indeed a peak for a bubble that popped, and TSLA lost more than half of its value within a month. That was 8 months ago. Right now, TSLA is worth triple its previous maximum price.

Another graph of $TSLA (Tesla Inc.) stock price, after crashing from the initial peak and going up once again, finally hitting a brief plateau

So, what does that all mean? Does that mean you should be happy that you bought if you bought, or sad if you didn’t? Well, not really. The point is, you can never know what will happen to the price of a stock. No one knows. Even “reputable” financial news sources play whack-a-mole with their headlines trying to explain what happened that day. Most of those websites will have headlines about correlation (happening at the same time) while implying causality. For example, CNBC had a headline on November 1, 2020, saying “Gold rises as pandemic worsens” while the body of the article does not mention the pandemic at all.

As my Statistics professor likes to remind me, correlation does not mean causation. Unfortunately, research shows that having causality, even when it is not real, makes it more likely that traders will overestimate the effect of the information. Research by Andreassen (1987) showed that participants made worse trades when they were given information that included causality, even though they were given more information in total.

We know that the vast majority of humans are just plain bad at trading stocks due to their cognitive pitfalls, but why do stock traders (people who buy and sell stocks professionally) still keep trying to make a profit off the market? Because they are not aware of their mistakes! They are all confident in their abilities to “beat the market”, and it is not just them being arrogant either.

Why are they so confident in their non-existent abilities then? That’s where metacognition comes in, which refers to their ability to assess their skills. The two main cognitive biases cause stock traders to think that they are better than they are hindsight bias and self-attribution bias.

First, let’s talk about hindsight bias, which is the tendency for people to overestimate their past abilities to predict events that happened since. You have probably experienced this when you have struggled with a riddle for a long time, and when given the answer, were confused by how easy it was. The problem is that our brains aren’t able to evaluate problems by blocking out some part of our experiences, and knowing the answer makes the problem, much easier! This happens everywhere from relationships to elections and even the Superbowl, as this blog post explains. As for trading stocks, Merkle (2017) surveyed professional traders on their past experiences and compared those responses to their actual transaction history. The analysis showed that stock traders overassessed their past performances, and those traders with higher errors also had more erroneous confidence in their performance.

Stock traders are also likely to chalk up failures to external sources while attributing successes to their own skills. This cognitive bias is called self-attribution bias, and an experiment conducted by Seppälä in 2009 showed that people who believed they answered a problem correctly were more likely to attribute their success to their skills and be more confident about the correctness of their future answers compared to participants who got a question wrong and subsequently didn’t show as big of a bias in their self-confidence.

When we combine these biases, humans turn out to be pretty bad at trading stocks rationally; even trained professionals have trouble analyzing their past performance and other metrics without falling into cognitive biases. Merkle (2017) provides further empirical evidence that these biases cause traders to take too much risk and muddle the self-assessment of their abilities.

Robinhood’s slogan is to democratize access to the masses by providing an easy-to-use app and enable small-scale trading by removing trading fees. This seems like a helpful mission at first, however, is the general public ready to handle this kind of access to financial markets? We have seen evidence that even professional traders are not great at behaving rationally, and the question is what happens when anyone over the age of 18 can download a phone app and start trading.

Acknowledging cognitive shortcomings is a great first step for preventing costly mistakes that occur due to cognitive biases. In this post, I’ve explored some ways in which the human brain isn’t too fit for stock trading, and doing so might result in financial loss. I hope that you take this knowledge and apply it to be careful with putting more money than you are comfortable losing to the stock market.

Works Cited
Andreassen, P. B. (1987). On the social psychology of the stock market: Aggregate attributional effects and the regressiveness of prediction. Journal of Personality and Social Psychology, 53(3), 490.

Kate Rooney, “Robinhood Reports More Monthly Trades than Rivals Charles Schwab, E-Trade Combined.” CNBC, CNBC, 11 Aug. 2020, www.cnbc.com/2020/08/10/robinhood-reports-more-monthly-trades-than-rivals-charles-schwab-e-trade-combined.html.

“Gold Rises as Pandemic Worsens, U.S. Elections in Focus.” CNBC, CNBC, 2 Nov. 2020, www.cnbc.com/2020/11/02/gold-markets-dollar-us-election.html.

Seppälä, A. (2009). Behavioral biases of investment advisors-The effect of overconfidence and hindsight bias.

Merkle, C. (2017). Financial overconfidence over time: Foresight, hindsight, and insight of investors. Journal of Banking & Finance, 84, 68-87.