As anyone who has had the patience or misfortune to listen to me speak on trading for more than five minutes will well be aware, I am fond of saying that trading is simple but not easy and it is. It only consists of three rules, if it is trending up buy it, if it is trending down sell it, and don’t bet the farm. Unfortunately, most investors and almost all professional money managers do exactly the reverse which explains their persistent lack of success.
And I agree it does sound glib, superficial, and dismissive but it is, unfortunately, true as a general statement about how trading works. But and there is always a but most things in life have a solution that sounds very simple, but which largely mask the complexity of the underlying problem. As an example, take weight loss. Losing weight is easy – the message is move more and eat less; as weight loss irrespective of Facebook will tell you is strictly governed by the laws of physics. If you have a negative energy balance you will lose weight it is that simple, but it is not easy. It is not easy because the superficiality of the statement move more and eat less glosses over the complex interactions of food, class, education, psychology and emotion. It is not until this very complex model is understood that the actual physics of weight loss becomes a thing.
The same is true in trading unless the relationship traders have with themselves and the market is addressed then simple statements such as buy low and sell high remain little more than homilies. Each decision we make in trading is a function of our evolutionary psychology, our perceptual filters, and our background. As can be seen the idea of understanding why people can’t trade suddenly becomes as complex as trying to understand why people battle with their weight. It is much more than that they simply have their RSI set to the wrong number – although there are probably thousands who would tell you that this was the problem before quietly retiring to the basement of their mother’s house where they live.
Consider the quote below by Jesse Livermore –
“I did precisely the wrong thing. The cotton showed me a loss and I kept it. The wheat showed me a profit and I sold it out. Of all speculative blunders there are few greater than trying to average a losing game. Always sell what shows You a loss and keep what shows You a profit. That was so obviously the wise thing to do and was so well known to me that even now I marvel at myself for doing the reverse.”Reminiscences of a Stock Operator
Consider this quote in light of Livermore’s background as an extraordinary speculator – if someone of his success falls into this trap then what hope is there for the majority of traders. Much has been written about why traders make the sort of mistake that Livermore did and unfortunately much of it again falls into the realm of having your RSI set to the wrong number. I want to move away from that and look at how complex this problem actually is and how it cannot be solved by simple statements – the simple statement might neatly encapsulate the problem but it goes no way to solving it.
If following this one simple rule is the key to trading success, why is it then that so many traders simply fail to pay attention to it? And if they did know the rule exists why do so many choose to ignore it. This question has puzzled trading psychologists for many years and over recent years a theory as to why it is so difficult for traders to cut their losses has gradually emerged.
To date, the most seminal work has been done by Daniel Kahneman and Amos Tversky who in 1979 postulated a concept known as prospect theory and frame dependence. Prospect theory relates to how we value certain outcomes. Whilst frame dependence looks at the decision-making framework that an individual adopts.
This framework can be thought of simply has how a decision is viewed in terms of its possible outcomes. In turn, 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.
What Kahneman and Tversky believed was that people do not make truly rational decisions when faced with a series of outcomes because the frames they used to make a decision were a function of their relative perceptual filters. A consequence of this was they believed in what has become known as opaque frames. An opaque frame is one where all the outcomes cannot be rationally evaluated, and the decision is made based upon the way outcomes are viewed.
In the world of finance, such a theory was tantamount to heresy because traditional approaches to corporate finance assumed that all frames were transparent. Transparent simply means that all possible outcomes are obvious and rationally evaluated. In effect, traders behave like logic-based machines with no biases and a complete understanding of the world and all possible outcomes. The belief in the rational investor is the cornerstone of most of modern finance.
This approach regarding how decisions are framed and outcomes valued is a cornerstone of why people struggle to minimize their losses. To summarize traders have the emotional maturity and rationality of a hormonal sixteen year old girl.
I want to look at framing in greater depth and then offer an accessory theory why the majority of individuals will continue to struggle to trade effectively if they dont begin to look deeper into their motivations and more importantly the decision-making process that flows from these motivations.
Traditionally, economic theory is based on the idea that traders are rational and therefore make rational decisions. These decisions are based upon a fair weighing of the consequences of all possible outcomes. A situation where all the outcomes can be viewed and examined with equal rationality is referred to as being transparent. People can see through the framing and evaluate the problem and its outcomes.
As stated earlier, our choices are influenced by how a situation is framed.
A problem is positively framed when the options at hand generally have a perceived to result in a positive outcome. It could be argued that all our decisions to buy shares are the result of a positively framed problem. Our expectation is that should be purchase BHP at the current price then it will go up and we will show a profit.
Conversely, negative framing occurs when the perceived probability weighs over into a negative outcome scenario. A negative outcome may be taking a loss and it is this failure to takes losses that we are interested in.
Fortunately for traders, Kahneman and Tversky began their exploration of prospect theory with work on loss aversion. In the world of finance, such a theory was tantamount to heresy because traditional approaches to corporate finance assumed that all frames were transparent. Transparent simply means that all possible outcomes are obvious and rationally evaluated. In effect, traders behave like logic-based machines with no biases and a complete understanding of the world and all possible outcomes. The belief in the rational investor is the cornerstone of most of modern finance. And it is unfortunately wrong.
To illustrate how they went about investigating the problem of loss aversion and why it occurs it is necessary to reproduce one of their original problems. Kahneman and Tversky presented groups of subjects with a number of scenarios and then asked them to make decisions based upon the information presented. However, this little problem generated by Kahneman and Tversky does fall into the trap I mentioned earlier about overly simple homilies being presented as answers to complex problems and I will come back to that in a minute. Consider the initial problem presented.
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 upon 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 acting on a stop.
As a trader’s 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 the 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 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 as one scenario, and a 100% possibility of losing $ 3,000 as 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.
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 example and apply different numbers. You now have the following scenario.
An 80% possibility to win $ 40,000,000.00 and the 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 postulated by Kahneman and Tversky they explain reality but they do not represent in some ways the reality of trading. Results in trading exist 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.
