T2W Trading Community

If you buy a stock for $50 and it reaches an all time high of $100, but you sell at $75, why do you feel that you've made a loss?

Minds and Markets
In most people's minds finance and economics are the domains of clear, quantitative thinking. Economists merely uncover financial truth one after another as they develop new mathematical tools for modeling capital and how wealth is created. Markets, likewise, are ethereal natural forces tapped into rather than created. In truth, the assumptions that underly the pricing models used for the past three decades are based on two basic principles:

People make rational decisions
People are unbiased towards new information

Meanwhile, down the hall on university campuses, researchers in cognitive science have uncovered evidence that humans are not quite the rational decision makers expected. Humans make decisions with limited information and rather than treat new information with independent probabilities, context and history are critical to our decision making.

Humans often make predictable cognitive errors. As George Soros states in his classic "The Alchemy of Finance", it was when he moved from stock analyst to fund manager that he found that what he thought and how he made decisions suddenly became of paramount importance, as his fund depended on his sound decision making in arenas not limited to picking stocks.

These biases affect novices and expert traders alike. The value of a particular financial instrument depends heavily on the perception of its value. How is value determined? Again, we feel this is simply a matter of relying on objective mathematics. Numbers are not enough to describe investor decision making.

Overconfidence
Take a simple coin toss. Ellen Langer showed that people are more willing to bet on the outcome before the coin is flipped than after. People behave as if their involvement makes a difference in value. You're thinking, "How foolish, I'd never make that mistake". If you're like most college students, you think you are above average. As a matter of fact, 82% of them do, according to a classic study by Ola Svenson. Overconfidence is a consistent bias humans show, and it shows up in the markets.

Overconfident traders trade too much. Overconfident traders believe their information and ability to act on it is superior to most and they will profit from their actions. This leads to excessive trading, which hurts profitability. Overconfidence also leads to higher risk taking. As John Nofsinger points out, this is partially due to the illusion of knowledge, the notion that more information improves decision making.

If I ask you what the odds of a dice rolling a 4 are, you would likely conclude 1 in 6. If I then tell you the die previously rolled a 4 six times in a row, you might be assign a greater likelihood on the dice rolling a 4, or the contrarians might say less. Although the dice has no memory, people do, and it affects their decision making. As we saw in Langer's research, the very act of participation changes one's sense of value. Thus the novice trader's new tools and research may act to instill excessive confidence in the decision making process.

Mental Accounting
In considering the past, investors often rely on what Novel Prize winner Richard Thaler dubs “mental accounting”. Sums of money are categorized as “losses” or gains” and then treated differently, counter to what the rational model of economics would predict. One experiment that demonstrates this by Hal Arkes and Catherine Blumer showing how the labels we assign costs affect our decision making. They asked subjects to consider this scenario:

“A family has tickets to a basketball game, which they have been anticipating for some time. The tickets are worth $40. On the day of the game there is a big snowstorm. Although they can still go to the game, the snowstorm will cause a hassle that reduces the pleasure of watching the game. Is the family more likely to go to the game if they purchased the ticket for $40 or if the tickets were given to them for free?”

The typical response was that the family was more likely to attend if they purchased the tickets. The cost is the same in either scenario. But the decision to attend affects the outcome people choose. By purchasing the ticket, the mental account of a cost for attending the show is created. To “close this with a loss” is aversive, and people believe that the goal must be attained by purchasing another ticket.

Not only was the basis of the decision factored, but it was shown that timing mattered as well:

“A family has long anticipated going to the basketball game, which will take place next week. On the day of the game there is a snowstorm. Is the family more likely to go to the game if they purchased the $40 tickets 1 year ago or yesterday?”

In this scenario, subjects thought the family would be more likely to attend if they just purchased the tickets. Although the time value of the money spent would be greater from a purchase a year ago, the psychological cost has diminished over time, and people are less likely to be hurt by the cost.

Risk Aversion
Mental accounting also accounts for the risk behavior traders exhibit. Richard Thaler also showed that people are more likely to accept a wager on a coin toss if they had just been rewarded money than if they had not. This “windfall” profit is classified as a bonus, and thus risk capital. The percentage of economics students willing to accept a bet of $4.50 in a coin toss went from 41% when they were not given any money to 77% when they were given $15.