Apr

27

Loss aversion is likely what differentiates the pro from the amateur. It strongly influences what people do with their money. It may contribute to the difference in the up and down behavior of the market.

Consider this situation: you are given $1000. You have to choose to a. take a risk– heads you get 1000$ more, tails you get 0$ more, or b. play it safe and you'll get 500$ more.

Most people would choose the "play it safe" option and run with the money.

In the market this approach generates little, very frequent profits for weak hands. It is the kind of profit taking attitude that you regret when you see prices going up another 15 points when you've just made 2. I think this approach also contributes to build momentum as players re-enter at higher prices not to be left out. Corrections are mild as they are the effect of short term profit takers.

Consider this situation:  you are given $ 2,000. You have to choose to: a. take a risk– heads you lose 1000$, tails you lose 0$ or b. play it safe and lose $ 500. Most people will choose to bet. And I tried it with friends. They are all convinced it is much better to bet because you want to avoid losing 500$. It is exactly the same bet both times actually. Each has a 50% chance.

"When faced with possible losses, people choose the risky alternative", it says in the book "Good Thinking" by Denise Cummings. "Most people would rather take a bet that could end up costing double the sure loss".

If this were an investment, this means you will hold onto an investment as it loses money, hoping it will regain its value. More likely than not you will ride it all the way down. We know what happens next. It is related to fear and greed, the main drivers in markets and life. When fear gets to extreme levels you have capitulation and the public liquidates near the low.

Researchers show that animals also do the same thing. An experiment was made with monkeys. The key mechanisms are that people respond more strongly to losses than comparable gains, and people respond to changes in relative gains and losses rather than absolute gains or losses (losing or gaining 10$ means more if you only have 20$ than if you have 200$).

Traders, or wanna-be traders, want to go home with a profit at the end of the day. Even a small profit but the P&L spreadsheet has to be green… One could try and quantify the effect of profit taking that provides the minimum level of satisfaction that psychologically forces a trader to close his or her position.

Similarly, one could try to define the level of desperation that finally forces the trader to a sort of liberation and relief from stress when he/she liquidates a big losing position. This would help define the average move of legs during choppy days, or could help anticipate accelerations after a certain amount of points moves.


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