The contrast effect is a cognitive bias where our perception of something is influenced by what came before it. Humans are particularly susceptible to this bias, especially when it comes to how we perceive stock prices and value. You would think a bottle of wine that costs $300 is cheap after looking at a list full of $1000 bottles, right?
Now think of how this impacts institutional investors and retail traders alike. It’s a common phenomenon to compare a stock’s recent performance to another unrelated stock, which inevitably influences perception and decision-making. Instead of assessing stocks objectively, traders may overreact based on comparisons that don’t truly matter—a classic example discussed in trading psychology.
A seminal paper provided the first evidence that contrast effects can distort prices in financial settings. The authors demonstrated that investors mistakenly perceive earnings news as more impressive if the previous day’s earnings surprise was bad and less impressive if the previous day’s earnings announcement premium was strong. This bias leads to predictable patterns in market returns following earnings announcements and impacts the distribution of earnings news over time.
How the Contrast Effect Skews Trading Decisions
Stock traders fall victim to the contrast effect in various ways:
1. Misjudging Stock Value Based on Recent Price Moves
If a stock has dropped 10% in a week, it might seem “cheap” compared to last week’s price, even if it’s still overvalued by fundamental or investment strategy measures. This is a form of investor reaction that leads to distorted judgments.
2. Overestimating a Stock’s Strength Compared to a Weaker One
If a stock is up 5% today, it looks like a strong performer. But if you’re comparing it to another stock that’s up 15%, you might incorrectly perceive it as weak and hesitate to buy. A recent journal by bayes demonstrated that even analysts systematically misjudge analyst forecast errors due to similar contrast-driven distortions.
3. Falling for Market Hype & Missing True Opportunities
If a particular sector is skyrocketing, stocks with only modest gains in that sector may seem “unimpressive,” even if they have strong fundamental analysis and room to grow. Traders often ignore investment opportunities that don’t stand out in the moment but have long-term potential.
4. Getting Trapped in Relative Thinking Instead of Absolute Performance
A trader may hold onto a stock that’s down 20% simply because another one in their portfolio is down 40%. The contrast makes the first loss feel more acceptable, even though cutting losses on both might be the best decision. Investor sentiment can make losses seem smaller when compared to worse-performing assets, leading to irrational choices.
Contrast effects cause traders to react emotionally rather than logically, leading to biased earnings forecasts and poor investment choices. These biases are not just theoretical constructs—they have been empirically observed in academic journals, influencing both retail investors and hedge funds.
The Role of Trading Systems in Mitigating the Contrast Effect
Systematic traders have an edge in overcoming psychological biases like the contrast effect. Here’s why:
Rules-Based Trading Eliminates Emotional Comparisons
A market-neutral trading system doesn’t get swayed by how one stock looks next to another—it simply follows tested investment recommendations.
Backtesting Confirms What Actually Works
Traders who rely on backtesting make decisions based on historical daily stock market swings rather than subjective perceptions. If a system proves profitable over decades, there’s no need to let recent stock movements dictate actions.
Clear Position Sizing Prevents Overconfidence
A well-defined position sizing strategy ensures that decisions aren’t based on how a trade “feels” in comparison to others but rather on characteristics of risk and solid risk premium principles.
Challenges Systematic Traders Face with the Contrast Effect
Even systematic traders can fall into the contrast effect trap if they’re not careful. Here are some common pitfalls:
Altering a Trading System Based on Recent Trades
After a series of winning trades, a trader may perceive their system as “less effective” if the next few trades are smaller winners, even if the system is still profitable overall. This leads to sequential performance judgments, which can skew a trader’s perception of what actually works.
Overweighting Certain Strategies Over Time
If one strategy in a trading portfolio performs well in recent months, traders may start doubting their other strategies, even though neutral strategies and diversification are key for long-term success.
Comparing a System’s Performance to Recent Market Moves
If the market has been trending aggressively, a mean-reversion strategy might seem weak by comparison. But abandoning it could lead to missed profits when the market reverts to its normal state. The timing of earnings announcements and price revelation often play a role in how traders judge their systems.
By being aware of these tendencies, traders can stay committed to their systems and avoid reactionary changes.
Actionable Tips for Overcoming the Contrast Effect in Systematic Trading
Stick to Your System & Ignore Short-Term Comparisons
A good investment strategy is designed to work over hundreds or thousands of trades. Don’t abandon it based on price reactions or another strategy’s recent performance.
Keep a Trading Journal to Identify Biases
Write down what influenced each decision in a trading journal. If you find yourself comparing one stock’s performance to another, highlight it as a reference point price warning sign.
Use Backtesting to Stay Objective
By running extensive intraday analysis, you’ll see that short-term fluctuations are meaningless in the bigger picture. This prevents you from making decisions based on misleading comparisons.
Set Predefined Entry & Exit Rules
Avoid subjective judgments by defining exact criteria for entering and exiting trades. This prevents decisions based on how a stock “feels” compared to another.
Hold Yourself Accountable
Find a trading mentor or accountability partner who can help you stick to objective rules rather than making sequential decisions based on faulty logic.
Frequently Asked Questions About the Contrast Effect in Trading
1. How do I know if I’m falling for the contrast effect in trading?
If you ever think, “This stock looks good compared to X,” rather than analyzing it on its own merits, you might be under the influence of the contrast effect.
2. Can backtesting eliminate the contrast effect completely?
Not entirely, but it significantly reduces its impact. When you see that a system works over decades, you’re less likely to second-guess it based on short-term comparisons.
3. Why do traders compare stocks even when they know it’s irrational?
The human brain is wired to compare. It helps us make sense of the world. Unfortunately, in trading, these comparisons can lead to faulty decisions.
4. How can I stop making decisions based on recent stock moves?
Use predefined rules for trading. If a stock meets your system’s criteria, trade it. If not, ignore it, regardless of how it looks compared to others.
5. What’s the biggest danger of the contrast effect in stock trading?
It tricks traders into reacting to noise rather than making data-driven decisions. This often leads to chasing trends, misjudging risk, or holding onto bad trades.
Conclusion: Trust Your System, Not Your Comparisons
The contrast effect can lead traders to make irrational decisions based on misleading price response comparisons. Instead of focusing on subsequent market events or relative performance, systematic traders rely on tested, rules-based neutral strategies.
The Trader Success System is designed to eliminate cognitive biases, providing you with the confidence to trust your investment training courses and stay consistent—no matter how the aggregate stock market behaves.
Ready to master systematic trading and remove emotional biases for good? Apply to join The Trader Success System and learn how to trade with confidence: Learn More Here
Trading Psychology and Psychological Bias Articles
To dive deeper into how other psychological biases affect your trading psychology and decisions as well as practical ways to overcome them, explore the articles below. For a comprehensive guide on mastering your mindset and building a resilient psychology, visit our Trading Psychology page.
- Action Bias in Trading
- Ambiguity Aversion in Trading
- Anchoring And Adjustment in Trading
- Anchoring Bias in Trading
- Authority Bias in Trading
- Availability Heuristic in Trading
- Bandwagon Effect in Trading
- Bias Blind Spot in Trading
- Choice-Supportive Bias in Trading
- Commitment And Consistency Bias in Trading
- Confirmation Bias in Trading
- Conservatism Bias in Trading
- Contrast Effect in Trading
- Decoy Effect in Trading
- Disposability Effect in Trading
- Disposition Effect in Trading
- Dunning-Kruger Effect in Trading
- Endowment Effect in Trading
- Escalation Of Commitment in Trading
- Familiarity Bias in Trading
- Framing Effect in Trading
- Gambler's Fallacy in Trading
- Halo Effect in Trading
- Herd Mentality in Trading
- Hindsight Bias in Trading
- House Money Effect in Trading
- Hyperbolic Discounting in Trading
- Information Bias in Trading
- Loss Aversion in Trading
- Money Illusion in Trading
- Narrative Fallacy in Trading
- Neglect Of Probability in Trading
- Normalcy Bias in Trading
- Optimism Bias in Trading
- Ostrich Effect in Trading
- Outcome Bias in Trading
- Overconfidence Bias in Trading
- Paralysis By Analysis in Trading
- Pessimism Bias in Trading
- Recency Bias in Trading
- Regret Aversion in Trading
- Representativeness Heuristic in Trading
- Salience Bias in Trading
- Selective Perception in Trading
- Self-Attribution Bias in Trading
- Status Quo Bias in Trading
- Sunk Cost Fallacy in Trading
- Survivorship Bias in Trading
- Trading Psychology in Trading
- Zero-Risk Bias in Trading
