T2W Trading Community

Thaler also showed that experiencing a small loss produces risk aversion to a fair bet, but if they lost significant money and offered the chance to “break even” a majority of students accepted, even if the bet was not fair. Losses can exacerbate losses.

One common phenomenon many traders know all to well is selling winning trading and holding losing trades. Hersh Shefrin attributes these to the desire for pride and avoidance of loss. If you record a trade with a profit and a trade with a loss, you may realize the profit to attribute a successful trade to your sound decision making, but avoid realizing a loss that speaks otherwise. Although this seems simple, capital gains tax incentivizes holding winners to avoid realizing capital gains and selling losers to reduce taxes owed - the opposite strategy that most traders pursue.

Terrence Odean examined 10,000 trading accounts from 1987 to 1993 from a national discount brokerage to see the percentage of winners and losers closed in proportion to the number of paper winners and losers held. He found sales represented 23% of the number of total gains and losers represented about 16% of total losses. In other words, investors are twice as likely to close winners than losers.

Anchoring and Adjustment
What counts as a gain or a loss is also relative to prior prices, not considered as independent of an investor's attention. A stock acquired at $50 and and achieves a year-end value of $100. A few months into the new year it is sold at $75. While this is objectively a $25 gain, the investor likely feels as if there was a loss. One classic decision-making bias Nobel Laureate Daniel Kahneman and Amos Tversky identified is this effect, called anchoring and adjustment. Meir Statman asked subjects this question:

"In 1896 the Dow Jones Industrial Average (DJIA) was at 40. At the end of 1998, the DJIA was at 9,181. The DJIA is a price-weighted average. Dividends are omitted from the index. What would the DJIA be at the end of 1998 if the dividends were reinvested every year?”

The correct answer is 652,230. Surprised? You may have been subject to the anchoring and adjustment effect. By starting at 9,181 and computing change from there, you are statistically more likely to guess a number close to that reference point.

Buying by the pack
The tenets of behavioral economics have profound implications for biases traders exhibit that have not predicted by mainstream models of valuation and pricing. Over the coming years these concepts will become better known and produce not only better predictive financial models but allow individuals to become better investors. Cognitive illusions and biases cannot be erased, just as one can't help but imagine the lights dancing on a movie screen as real people. Traders seeking to avoid these mistakes would do well to identify these biases in their own trading and create incentives for avoiding them. Just as smokers are willing to pay more by the pack to limit their smoking, developing trading programs that discipline at a small cost (for instance, liquidating trades with a certain loss that perhaps have a potential for future profit) can prove useful.

"Trading Futures and Options on Futures involves substantial risk of loss and may not be suitable for all investors. Each investor must consider whether this is a suitable investment."