Amos Tversky and Daniel Kahneman are recognized as the forerunners of Behavioral Economics. This branch of the social sciences has increased its popularity following the publications of a large number of authors and scholars of the subject, as well as the increase in its use and relevance in different tools of investment and asset management. If we add to all this the Nobel Prize in Economics awarded to Richard Thaler, it is clear to us the renewed interest in the subject.
The psychologists mentioned at the beginning of the note are the minds behind the Prospect Theory, among many other transcendental research works. This publication demonstrates the deficiencies of the Classical Economic Theory with respect to decision making and aversion to risk based on absolute terms. It proposes that these decisions are taken within a frame of reference, in addition to concluding how human beings assign greater weight to losses than to gains of similar proportions.
That is, the negative utility perceived by a loss is greater than the profit generated by a gain of the same dimensions. In other words, it hurts more to lose than we like to win.
It is worth mentioning that Kahneman was also awarded the Nobel Prize in Economics in 2002, while Tversky, unfortunately, died in 1996 victim of skin cancer.
Returning to the study on how human beings perceive losses, it will help us understand the reactions that traders usually have when the stock market falls.
One of the experiments where we can see reflected the asymmetry between gains and losses is the following:
Let’s assume that someone offers you two options. A guaranteed prize of $900, or entering a raffle where you have a 90% chance of winning $1,000. The expected value of both alternatives is equivalent, so to speak, however, most people opt for the safe gain of $900.
Now, the downward analogous case: You can choose between paying $900 for sure, or enter a raffle where you have a 90% chance of losing $1,000.
The results of repeating this survey indicate that there is an inconsistency in preferences. People who chose to earn $900 (certainty) in the first exercise are more likely to choose the raffle in the second scenario.
How do you see this reflected in the traders?
Many operators, mainly the less experienced ones, have a tendency to pay attention to their emotional side, or fall victim to these biases that do not seem to obey the strict rational rules.
Usually, active traders buy shares with previously determined parameters, an expected gain (target price) and a limit of tolerated loss (stop loss), and let the market’s supply and demand shock determine whether they will win or lose.
Novice traders tend to show anxiety to collect earnings in advance ($900 certainty), while, when luck does not smile upon their trades, they cling to losing positions (thinking that they have a slight chance of not losing $1,000).
The effect of frequently falling into this bias would be inconsistencies in the results against the expectations of your models. You probably win as often as you expected, but your winnings will be smaller than projected, and on the contrary the losses will be higher.
This does not mean that losses in trading have to be eliminated absolutely, this suggests that:
Inconsistencies in the execution of a strategy, product of emotional factors, often reduce the results against what was expected in the design of the same.