Confirmation Bias and Risk Management

The Federal Reserve dominated global market moves in 2022 as they finally acknowledged the inflation problem that had been brewing for some time.

The bank went from an ultra-loose monetary policy setting to tightening at break-neck speed that started in March. 425 basis points were added to their target rate over the year.

Treasury yields responded in kind with the benchmark 10-year note starting the year near 1.50% before climbing to a peak at 4.33% in October. Other parts of the curve saw larger increases, and this helped to underpin the US Dollar.

The ‘big dollar’ had started to show characteristics of a bullish trend in the latter half of 2021 and then went on a tear and rallied hard on the change in policy in early 2022. The ascending trend accelerated to a high in September.

This expanding trend lent itself to buying on dips and lightening up on rallies. The strategy worked well until it didn’t. By early November, the break of trend had become apparent. While long US Dollar trades were exited, a short US had not been considered.

Rather, due to the success of playing from the long side, a buying dips strategy continued. This came about because of the confirmation bias from being profitable by deploying this approach.

The saving grace in this period was appropriate risk management techniques. While losses were incurred, the damage was minimized by having stop losses in place. Additionally, trade size was appropriate, and discipline was maintained around maximum daily, weekly and monthly losses from any one strategy.

The lesson here is the need for flexibility and recognizing that past trades are over and move on. The path behind might provide clues to future direction but letting go of anchored beliefs and biases can provide a clearer and potentially more profitable outlook.

Risk management remains a core component of successful trading and while this example illustrates the minimizing of loss, solid discipline can potentially lead to better execution on profitable trades.