Daniel Kahneman, the Princeton professor and first psychologist to win the Nobel in Economics, awarded for studies he conducted with Amos Tversky, attributed market manias partly to investors’ “illusion of control” calling the illusion “prospect theory.” Kahneman studied the intellectual underpinnings of investing — how traders estimate odds and calculate risks — in order to prove how often we act from the mistaken belief that we know more than we do. Bottom line, according to Kahneman, is that we are victims of our own overconfidence.
Johan Ginyard at Uppsala University, Department of Psychology, analyzes Kahneman’s work with his piece, “Position-Sizing Effects on Trader Performance: An Experimental Analysis”:
Why does not everybody minimize losses and maximize profits? Traditionally, economic theory is based on the idea that market [participants] are rational and therefore make rational decisions. Feelings and biases do not influence the [participants]s’ judgement, only relevant information effects their behavior. Decision-makers decide on basis of the probability of each alternative outcome and select the alternative giving the maximum return. This view is not supported without exception. 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 probability to result in a positive outcome.
Negative framing occurs when the perceived probability weighs over into a negative outcome scenario. In one…experiment, the participants were to choose one of two scenarios, a 80% possibility to win $ 4,000 and the 20% risk of not winning anything as opposed to a 100% possibility of winning $ 3,000. Although 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 participants had to choose between a 80% possibility to loose $ 4,000 and the 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 they are described as definitive, as opposed to situations where they are described as possible. This is done even though a rational economical evaluation of the two situations lead to identical expected value. People tend to 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, will inflict investors trying to avoid such a loss. As a consequence, they will take a greater risk and gamble in a losing situation, holding on to the position in hope that prices will recover. In a winning situation the circumstances are reversed. Investors will become risk averse and quickly take profits, not letting profits run. This goes for the professional investment managers as well, and this is not only a tendency in the Western world. Costs, that is, losses, made at an earlier time may predispose decision-makers to take risks. They are more risk seeking than they would be if they had not made the earlier loss. This effect is referred to as the sunken cost effect and results in organizations and individuals throwing good money after bad in order to make up for the loss.
The loss already incurred makes the context equivalent of a negative frame, but with an increased commitment, for example, buying more shares makes a recovery possible, although uncertain. Nothing new under the sun, especially in the markets. Investors and traders, shifting in risk tolerance according to positively and negatively framed situations, show no risk aversion, but an aversion against losses. Loss aversion applies when one is avoiding a loss even if it means accepting a higher risk. The preference for risky actions to avoid an impending loss over less risky options just to minimize the loss and bite the bullet can be explained by ‘loss aversion’.
It has been described that selling assets that have gained value and keeping assets that have lost value as Disposition effect in a recent experimental study. The disposition effect is based on two characteristics of prospect theory, namely the tendency of individuals to value gains and losses relatively a reference point and further, the tendency to be risk-seeking in situations where a loss might occur and risk averse in situations where a certain gain is possible.
[One] study showed that participants did sell their winners and kept their losers. Being poor Bayesians, is that our lot, or is this disposition effect possibly alterable? Is it conceivable adopting the behavior of the market wizards or at least avoiding the most flagrant mistakes? Is it determined by chance if one is behaving like Nick Leeson, trading Baring’s Bank into bankruptcy, or like Michael Marcus, who went bankrupt in the beginning of his career and later turned $30,000 into $80 millions?
We thank Johan for his permission to publish this excerpt. His full study is available here in PDF format.
What Prospect Theory Explains About Trading Failure
The 80/92 split from Ginyard’s experiments is the quantified version of the most common trading failure pattern: holding losers and cutting winners. In the gain scenario, 80% take the certain smaller amount rather than risk it for a higher expected value. In the loss scenario, 92% gamble rather than take the certain smaller loss. Both behaviors produce the same outcome in a trading account: winners are exited before their potential is realized and losers are held until they are catastrophic.
The Leeson versus Marcus contrast that closes Ginyard’s excerpt is the human version of the same experiment. Leeson held losing positions and added to them, escalating the gamble to avoid accepting a certain loss, until the position destroyed one of the oldest banks in the world. Marcus accepted losses early in his career, including a bankruptcy, learned the rules that prevent that pattern from recurring, and turned a small account into a major fortune. The difference is not intelligence. It is the structure of decision-making: rules that force the stop loss versus the psychological freedom to gamble on recovery.
Systematic trend following is the structural solution Ginyard’s question implies. The disposition effect, selling winners early and holding losers, is produced by loss aversion operating on real-time trading decisions. Remove the real-time decision by encoding the correct response in rules built before the position is opened, and the disposition effect cannot operate. The stop loss takes the certain smaller loss automatically when it is hit. The trailing exit holds the winner until the price action itself signals the trend is over. Neither decision is made in the emotionally pressured moment when the bias is most acute. Both are made in advance by the rules, which have no emotional state and no preference for one outcome over another.
Frequently Asked Questions
What is the disposition effect in trading?
The disposition effect is the empirically documented tendency of investors to sell positions that have gained value too early and hold positions that have lost value too long. It is produced by two features of prospect theory: the tendency to be risk-averse when a gain is possible (take the certain profit) and risk-seeking when a loss is possible (gamble on recovery rather than accept the certain loss). Both behaviors are exactly wrong for maximizing trading performance.
Why do investors gamble on recovery rather than accept a defined loss?
Because a certain loss feels more painful than a probabilistic loss of the same expected value. Accepting the stop loss makes the loss permanent and certain. Holding the position keeps open the possibility, however small, of recovery. Loss aversion causes the investor to prefer the gamble on recovery even when the expected value of holding is lower than the expected value of exiting. This is the behavioral mechanism that converts small losses into large ones.
What is the sunk cost effect and how does it compound trading losses?
The sunk cost effect is the tendency to continue investing in a losing position because of the loss already incurred, rather than evaluating the position on its current forward-looking merits. Investors who have lost money on a position feel committed to recovery in that specific position. They add capital to average down, or hold past rational exit points, because the past loss creates a psychological obligation to make it back in the same trade. The loss compounds because more capital is now at risk on a position the market is consistently valuing downward.
How does systematic trend following eliminate the disposition effect?
By moving the exit decision from the emotionally pressured real-time moment to a rules-based framework built before the position is opened. The stop loss fires automatically at a predefined level, taking the certain smaller loss without requiring the trader to overcome loss aversion in the moment. The trailing exit holds the winner mechanically until the market’s own price action signals the trend is over, preventing the risk-averse early exit that cuts short the position’s full potential.
Trend Following Systems
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