If I told you that you could avoid the risk of a one-in-a-thousand chance of death, how much would you pay for the service? Now what if I had posed the question differently? How much would you need in order to accept the risk of a one-in-a-thousand chance of death? When Professor Richard Thaler put these questions to different groups of graduate students he found that, on average, they answered $200 to the first question, and $10,000 to the second. Quite a discrepancy given that both scenarios offer the same odds. The phenomenon has been labelled “the failure of invariance” and it demonstrates that the way an issue is framed can cause people to make radically different choices, even when the probabilities are essentially the same. Thaler is one of the best known researchers in behavioural finance, a sub-field of behavioural economics, which looks at the psychological factors behind how people weigh financial decisions.
One of the first pieces of wisdom you are likely to come across as a trader is that rational investors cut their losses and run their profits. Behavioural economics has been instrumental in demonstrating that human beings have certain cognitive biases in place that actually cause them to do the opposite, and our behaviour when trading suggests that we are anything but rational, self-interested and unemotional, as is held by the neoclassical model of economics. Nobel Prize winner Daniel Kahneman demonstrated in his pioneering work with Amos Tversky that “risk aversion in the positive domain is accompanied by risk seeking in the negative domain”, in other words people are far more likely to take on risk to avoid a loss rather than to make a gain.
When asked whether they would prefer an 80% chance of winning $4000, or a guaranteed sum of $3000, 80% of Kahneman and Tversky’s test subjects opted to take the $3000. No surprise there. But when asked whether they would prefer an 80% chance of losing $4000 over a guaranteed loss of $3000, 92% of the group opted to risk a highly probable loss in order to avoid taking a certain hit. This was repeatedly demonstrated using a number of different variations of the problem, and was presented in their seminal paper titled: Prospect Theory: An Analysis of Decision Under Risk, which is still the most cited paper ever published in the peer-reviewed journal Econometrica.
These are but a couple of examples of how you are hard-wired to lose the shirt off your back when trading, but what’s even more staggering is that these findings completely predate the retail forex industry. Kahneman and Tversky’s paper was published as far back as 1979, and the thought experiment I opened with was published in Thaler’s paper: Toward a Positive Theory of Consumer Choice, which appeared in the Journal of Economic Behaviour and Organization in 1980. That the above insights have yet to trickle down to most traders is remarkable, especially given the disadvantages beginners come to the market with in terms of limited knowledge and experience. You would think that a weakness as obvious as this would be one of the first things that traders attempt to correct in order to improve their chances of success. Evidently this is not so, and suddenly that ever-popular statistic, that only 5-10% of traders manage to be profitable on the forex market, starts to make great deal more sense.
The emotional default settings we inherited from our ancestors were probably essential to our survival on the African savannah, but they spell death for our trading account balances when predators are replaced with markets. As an adversary the market is the most complex set of interrelationships known to mankind, an environment that combines a truly staggering overabundance of conflicting data with utterly ambiguous feedback. So perhaps it should come as little surprise that we are so psychologically ill-equipped and react in fundamentally irrational ways when faced with such complexity; as evidenced by the asymmetry between the way we naturally weigh gains and losses in the examples above, or the fact that traders have been shown to consistently trade against the trend, buying falling markets and selling rising markets, or that the random reinforcement provided by trading feeds our irrationality and sends our pattern recognition faculties into overdrive. Then there’s the overconfidence problem, or the “hard-easy” effect as it has been dubbed, which basically states that, entirely contrary to what you might expect, people’s overconfidence actually increases as a given task becomes more difficult.
Trading psychology has been a buzzword for years, but its insights don’t seem to be hitting the mark yet. Perhaps this is because there is no quick and easy fix to the head you carry on your shoulders, no ten steps to upgrading your brain’s operating system from homo sapiens sapiens, to homo economicus. Still it’s probably the most useful thing you can possibly do in terms of ROI if you are serious about the business of trading.
I’ll conclude with a quote. In his excellent book The New Market Wizards: Conversations with America’s Top Traders, Jack Schwager interviews mathematician William Eckhardt, who frames the issue most elegantly when he says:
“If a betting game among a certain number of participants is played long enough, eventually one player will have all the money. If there is any skill involved, it will accelerate the process of concentrating all the stakes in a few hands. Something like this happens in the market. There is a persistent overall tendency for equity to flow from the many to the few. In the long run, the majority loses. The implication for the trader is that to win you have to act like the minority. If you bring normal human habits and tendencies to trading, you’ll gravitate toward the majority and inevitably lose.”