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Trading and Behavioral Finance

While the cry that the markets work by psychology has become almost axiomatic, most traders have little understanding of the internal forces pushing and pulling them on a daily basis. The fact is behavioral finance has made important contributions to understanding human behavior in the trading arena and it's important that novice and experienced traders alike are aware of how even the simplest changes in the markets and their own - very human - reaction to these changes can effect their trading performance.

Kahneman and Twerski's (1979) work on prospect theory - looking at how individuals weigh up the chance of gain or loss in relation to perceived risk - represents some of the better-known research. Their findings show that although traders may generally try to avoid taking a risk when they're facing the prospect of a gain, when they're facing the prospect of a loss they can actually be drawn to make more risky investment choices. Kahneman later won a Nobel Prize for this. Other important work has centered on loss aversion, where gains and losses are viewed asymmetrically. Simply put, the loss of a dollar is felt, emotionally, far more keenly than the gaining of a dollar. There's also preferential bias where traders tend towards making decisions that are in accordance with their own preferences and biases rather than solid information - including that coming from the market that should prompt a following of the trend. Similarly, the illusion of validity occurs when traders seek confirmatory evidence of personal beliefs in patterns of financial data. While hindsight bias shows that traders will tend to remember and magnify past successes and minimize or forget past failures. These are but a few of the many personality characteristics that cause traders to make systematic mistakes on a regular basis. Moreover, they are not only tied up with overconfidence, where market highs or trading successes can lead to a belief that things will only keep on improving (or will keep on getting worse), but also to overreaction, which underlies crowd effects and forces the markets to move with excessive momentum.

Besides their importance to traders generally, these effects also go a long way to explaining why so many new traders fail early on in their careers.

Overall, traders ignore these effects at their peril!

Articles in category "Psychology"

There is one article in this category.