Cognitive Biases

Omission Bias

We look at cognitive biases in the Behavioral Finance arena specifically to understand how they affect our decision-making. While we would like to believe that our decisions are all made in a rational manner, the reality is much different. We cannot help but be influenced by these naturally occurring biases and will only move more to the rational side of decision-making by consciously guarding against them.

Additionally, putting policies and procedures in place to guide our trading can help keep us focused appropriately.

Wikipedia defines Omission Bias as a tendency to judge harmful actions as worse than equally harmful omissions (inactions).

In simple terms, the Omission Bias plays out when we choose to act in irrational ways that divorce us from responsibility for the outcome. A direct action we take that results in losses is felt more strongly than when we take no action yet experience the same loss.

Here are some Omission Bias examples.

There is a clear connection to the Disposition Effect as it influences our risk-taking tendencies.

Lesson and Actions

Investors can easily fall into the trap of the Omission Bias. For example, an investor may have a large gain in a position and is experiencing the Disposition Effect. The investor could take direct action and sell for the gain. Or, the investor could put a very tight stop under the position. In the latter case, the investor can claim he was 'stopped out' (the market did it) rather than taking accountability for selling.

When you are looking for protection with a stop-loss, consider placement. If you are putting it inside the Average True Range (ATR) of the equity, it is likely that you are falling victim to the Omission Bias.

A true stop-loss would be placed at some clear level under the current price, something we train for in our TAP^© training.