Common Psychological Traps in Copytrading
9 min read
Often, the difference between success and failure in investing lies in mindset and psychology. It is very easy to forget the influence your mindset has on your personal finances, especially in copy trading. Since Copy trading allows you to leverage the skill and experience of seasoned traders, the chances of coming face-to-face with psychological and mindset limitations and challenges are lower compared to direct trading. However, it doesn’t take away the presence of those demons, and sooner or later, you’ll be forced to either address them or fall prey to them.
All investors, including the most competent ones, are not immune to the various cognitive biases and emotional traps involved in investing, irrespective of the assets at play, and many times, they pay dearly for it through losses.
However, being aware of these traps and how they work brings you a step closer to learning how to overcome them.
I will be exploring a few of the most prominent psychological and emotional traps involved in copy trading. As you read, take note of those that you find most relatable. Trust me, you’ll be glad you did.
The Illusion of Control
The illusion of control is a psychological trap where investors believe they have more influence over their outcomes than they actually do. In the context of copytrading, this bias can manifest when you think that following a successful trader will guarantee your own success. While copying a skilled trader’s strategies can improve your chances of making profitable trades, it does not mean you control the market or the trader’s actions.
Understanding the Illusion of Control:
Misplaced Confidence: Overestimating your ability to predict market movements or influence outcomes, causing overconfidence, is the most common symptom of having the “illusion of control” syndrome. Even if a trader consistently performs well, external market forces—such as economic events or geopolitical tensions—can impact results unpredictably. Especially with volatile assets like cryptocurrency, things tend to go south very quickly.
Impact on Decision-Making: The illusion of control can make you lazy, complacent, and careless, causing you to assume that your investment decisions are infallible simply because they are based on the actions of a successful trader. In most cases, this is the result of the absence of due diligence and a failure to diversify or adjust your strategies in response to changes in market conditions.
Mitigation Strategies: To counteract the illusion of control, you need to create a system and habit of regularly reviewing your investment strategies, staying informed of market conditions, while remembering that no investment is without risk. In addition, a diversified portfolio and realistic expectations are also crucial to managing the illusion of control.
Herd Mentality and FOMO
You know that scenario where everyone is doing something because it's trendy, despite how foolish and wrong it seems, and you are tempted to do the same? That’s a classic picture of what the Herd mentality at work looks like. Herd mentality refers to the tendency for investors to follow the actions of a larger group, often leading to irrational decision-making. In copytrading, this is particularly associated with the fear of missing out (FOMO). When a specific trader or asset experiences substantial gains, there is the temptation to rush to copy trades without proper analysis, simply because everyone else seems to be doing it.
Understanding Herd Mentality and FOMO:
Psychological Pressure: The desire to conform and avoid feeling left out can drive you to mimic trends blindly. This can result in buying assets that are overvalued or engaging in trades without a thorough understanding of their risks.
Consequences: Such impulsive actions can lead to significant losses, especially if the initial excitement surrounding a trader’s performance is not sustainable. Market trends can change quickly, and what was once a hot investment could turn cold.
Mitigation Strategies: To avoid falling into the trap of herd mentality and FOMO, you need to prioritize doing your own research and analysis before making decisions. Setting clear investment goals and adhering to a well-thought-out strategy can help you maintain discipline and reduce susceptibility to market noise.
Overconfidence Bias
Overconfidence bias occurs when individuals overestimate their own knowledge, skills, or abilities. There is really nothing wrong with believing that you are a good investor, but overrating your skills is where the problem is. In copytrading, this bias usually comes up after a consistent period of success, making you think that you can predict market movements with greater accuracy than you actually can. This trap is also closely associated with the illusion of control.
Understanding Overconfidence Bias:
Risk-Taking: People with the overconfidence bias tend to take higher risks above their usual risk appetite, believing that their previous chain of success guarantees their success. As always, this leads to poor risk management and very reckless trading behaviors.
Reality Check: It’s very easy to forget that even the best traders go home with losses on some days. Overconfidence may blind you to the potential risks and existing changes in market conditions, including the adjustments that you need to make.
Mitigation Strategies: To deal with overconfidence, you need to consistently review your trading strategies, no matter how good they are. Seeking feedback from other traders and continually learning about market dynamics will also help you spot areas for improvement and maintain a more realistic view of investing.
Confirmation Bias
Another psychological trap that you should be aware of is the “Confirmation bias”. The confirmation bias is the tendency to favour and fixate on information that confirms pre-existing beliefs while subconsiously ignoring evidence that proves otherwise. As a copytrader, you may find yourself selectively focusing on positive news about an asset or trader despite the warnings or negative information surrounding the subject.
Understanding Confirmation Bias:
Selective Information Processing: A sign of the confirmation bias at work is actively seeking out sources that reinforce your views about a trader’s performance, leading to skewed decision-making. This can prevent you from seeing the potential risks involved or making necessary adjustments.
Impact on Decisions: Relying on confirmation bias can result in holding onto losing positions longer than advisable or investing in assets with potential red flags. This can lead to substantial losses and missed opportunities.
Mitigation Strategies: To overcome confirmation bias, you should strive to gather information from a variety of sources and viewpoints. A critical evaluation of all available data, considering alternative perspectives, can help you make smarter, balanced, and informed decisions.
Loss Aversion
Loss aversion refers to the tendency of you as a copy trader to prefer to avoid losses rather than actively acquire equivalent gains. This psychological trap can significantly impact copytrading, as you may react more strongly to potential losses than to possible gains.
Understanding Loss Aversion:
Behavioral Impact: You may find yourself holding onto losing positions in the hope of a market reversal, rather than cutting your losses and reallocating resources to more promising opportunities. Conversely, you may be reluctant to take profits due to fear of missing out on further gains.
Decision-Making: Loss aversion can lead to suboptimal decision-making, such as holding onto losing trades too long or avoiding profitable trades out of fear that you may miss out on additional profits.
Mitigation Strategies: Implementing risk management strategies, such as setting stop-loss orders and regularly reviewing investment positions, can help mitigate the effects of loss aversion. Developing a disciplined approach to taking profits and cutting losses is also essential.
Sunk Cost Fallacy
The “Sunk Cost fallacy” occurs when you continue investing in a losing position based on the amount already invested, rather than evaluating the potential for future returns. This usually ends with you maintaining your commitment to a trader or asset even when it’s clearly not worth it to do so.
Understanding the Sunk Cost Fallacy:
Emotional Attachment: If you’re deep in the “sunk cost fallacy” trap, you may struggle to cut losses due to emotional attachment to your initial investment or the desire to avoid admitting a mistake. This can lead to continued investment in losing positions.
Impact on Returns: Failing to cut your losses and move on can result in further financial losses and missed opportunities to invest in more promising assets.
Mitigation Strategies: To avoid falling into the sunk cost fallacy, you should base decisions on the potential for future returns rather than past investments. Regularly reviewing and reassessing the performance of traders and assets can help you make more objective decisions.
The Halo Effect
The halo effect is a cognitive bias where your perception of a particular trait or achievement influences your overall evaluation of a person or entity. In copytrading, you may start seeing a trader as exceptional based on a single success, overlooking other aspects of their performance.
Understanding the Halo Effect:
Overgeneralization: You may begin to assume that a trader who performs well in one area (e.g., a specific cryptocurrency) will excel in all areas. This can lead to misguided decisions if the trader’s skills are not as strong in other market conditions.
Impact on Judgments: Relying on the halo effect can result in investing based on incomplete or biased information, potentially overlooking crucial factors such as risk management practices or the trader’s performance during different market conditions.
Mitigation Strategies: To counteract the halo effect, you must relate with and evaluate traders and assets based on a comprehensive review of their performance across various conditions. Considering a trader’s overall strategy and risk management approach is essential for making well-rounded decisions.
Overreliance on Past Performance
While past performance can provide valuable insights, it is not a guarantee of future success. Overreliance on historical performance can make you overlook changing market conditions and evolving strategies.
Understanding Overreliance on Past Performance:
Changing Market Dynamics: Market conditions can fluctuate due to economic, political, and technological factors. It is important to note that a trader’s past success does not necessarily predict future results, especially if their strategies do not adapt to new conditions.
Impact on Decisions: Focusing solely on past performance can lead to poor investment choices if you ignore other important factors such as current market trends, risk management practices, and the trader’s adaptability.
Mitigation Strategies: When evaluating traders, consider their ability to adapt to changing market conditions and their overall investment philosophy. Additionally, reviewing their risk management practices and how they respond to market volatility can provide a more comprehensive picture of their potential for future success.
Conclusion
One of the amusing and scary things about all of these psychological traps is that they may be responsible for the losses and disappointments you may have been experiencing in your copy trading journey without you being aware. Since these biases affect not just your copy trading endeavours but other areas of your life, it is essential to identify those that influence you negatively.
Being aware of them allows you to create systems to help you curb them and slowly limit their impact on your copytrading experience, and reading this article just allowed you to take the first step in that direction.
What psychological bias did you find most relatable? Share them in the comment section!
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