IG Markets community blog recently printed an article with the title What Is The Number One Mistake Traders Make? In this piece, the author looked at the impact of Prospect Theory on traders’ decision making and it repeats what I think is the mistake used when applying this to trading. At its core Prospect Theory is about decision framing and the impact this has upon financial decisions – the conclusions reached from this are then extrapolated to traders but I believe there is a flaw at the heart of Prospect Theory in that it fails to look at the emotional impact of decision making – note I said emotional not psycholgical. And when the problem is framed within a trading context it is in some ways the wrong problem.
To get a sense of this it is best to reproduce the original problem in full –
One group of subjects was presented with this problem.
- In addition to whatever you own, you have been given $1,000.
You are now asked to choose between:
- A sure gain of $500
- A 50% chance to gain $1,000 and a 50% chance to gain nothing.
Another group of subjects was presented with another problem.
In addition to whatever you own you have been given $2,000.
- You are now asked to choose between:
- A sure loss of $500
- A 50% chance to lose $1,000 and a 50% chance to lose nothing.
In the first group, 84% chose A. In the second group, 69% chose B. The two problems are identical in terms of net cash to the subject; however, the phrasing of the question causes the problems to be interpreted differently.
Now consider this in the language of trading, based on the results of question one, traders are more likely to opt from closing down a winning position quickly rather than allow the position to run for a potentially higher gain. Conversely, traders are more likely to gamble with a loss rather than act on a stop.
As a trader one of our key performance statistics is our expectancy, we can even apply this concept to the rather artificial decisions made by experimental subjects. Consider the second style of problem, this time we will frame it as a set of decisions made by traders.
Imagine two groups of traders. The first group is asked to choose one of two scenarios. An 80% possibility to win $ 4,000 and a 20% risk of not winning anything or the chance of a 100% possibility of winning $ 3,000.
Traders consistently opted for the certainty of a guaranteed win rather than a chance to make a higher return. The decision to opt for the guaranteed return is made despite it having a lower expectancy. The riskier choice had a higher expected value ($ 4,000 x 0.8 = $ 3,200), 80% of the participants chose the safe $ 3,000.
When traders had to choose between an 80% possibility to lose $ 4,000 and a 20% risk of not losing anything in one scenario, and a 100% possibility of losing $ 3,000 in the other scenario, 92% of the participants picked the gambling scenario.
This framing effect, as described in Prospect Theory, occurs because individuals over-weight losses when the loss is framed as a maybe situation. The stock may get better so I won’t act on the stop loss. Traders fear losses more than they value gains. A $ 1 loss is more painful than the pleasure of a $ 1 gain. Describing a loss as certain, and therefore more painful to a trader. As a consequence, the trader will adopt any behavior that allows them to delay the realization of the loss will inflict investors trying to avoid such a loss.
Traders, therefore, become risk-seeking when they should be risk-averse. The tendency is to gamble with a losing position or even add to it. The buying of more shares offers a faint hope of recovery. Such an approach is the victory of the irrational over the rational and guarantees that such an afflicted trader will never succeed. This is undoubtedly true from my own observations of others and in particular my observation of myself. However, there is a wrinkle in the original problem in that it is not presented within the framework of trading. Trading involves a continuum of returns, not just a single one-off bet. To truly represent the thinking of traders it would have to be presented as not a single trial but rather part of 1,000 trials to reflect the reality of trading. But there is another problem with how this problem is presented – it doesn’t take account of the emotional impact of financial decisions – note I didn’t say psychological impact. Nor does it withstand scaling up.
When we offer up a model to explain behavior we must be able to scale up the model and still arrive at the same conclusion. So let’s take our second expectancy example and apply different numbers. You now have the following scenario.
An 80% possibility to win $ 40,000,000.00 and a 20% risk of not winning anything or the chance of a 100% possibility of winning $ 30,000,000.00.
In reality, there is no conceivable reason to opt for the safer option despite an understanding you may have of behavioral finance. And this is the difficulty of things such as those postulated by Kahneman and Tversky they explain reality but they do not represent in some ways the reality of trading. Results in trading exist on a continuum, whereas this style of experimentation operates as isolated events and as we saw in my somewhat ridiculous example it falls down when scaled up. However, it doesn’t invalidate their motion of framing it simply puts a real-world wrinkle in the problem.
Kahneman and Tversky did build a framework for understanding and codifying why people made the decisions they did and this set in motion the idea that behavioral finance could go some way to explaining why concepts such as Modern Portfolio Theory didn’t work as expected. So the decisions traders made were a function of the perception of possible outcomes is defined by the formulation of the problem and by the norms, habits, and personal characteristics of the decision-maker. In essence, our responses to problems are a function of how we see the world. So we have somewhat come full circle in that we are back to our starting point of understanding our motivations which is exactly how the problem of weight loss is solved. Unless traders can work out their internal motivations which are a function of upbringing, education, and personality then trading will forever remain extremely difficult.