In the 1970s, two university behavioral science researchers, Daniel Kahneman and Amos Tversky, published a series of articles on judgment and decision making.1 Their research challenged what economists had long assumed to be true: that people act rationally when making decisions about money and finances. They discovered that people often make illogical decisions when attempting to manage risk. Their findings opened up a new area of study, behavioral finance, that looks at the psychology of trading and the role emotions, thoughts, and behaviors have on our financial decisions.
Emotional Tail Wags the Rational Dog
Understanding how emotional reactions manifest themselves, to what degree, and how they can affect decisions is an important step in taking control of your trading performance. There are two different parts of our brain used when making a decision:
Our prefrontal cortex, or outer brain, is the part of the brain that makes us uniquely human. It controls our ability to organize information, compute probabilities, and plan for the future. The outer brain’s function is to translate emotions, “logically” assess a situation, and produce a decision.
Our limbic system, or inner brain, is the primal part of our brain—similar to that of other mammals. It controls emotions such as fear and excitement. It also drives our instincts of seeking out pleasant and useful things like fresh food and clean water and steering us away from unpleasant or dangerous things like poisonous plants or the edge of a sharp cliff. This part of the brain effectively holds shortcuts to decisions, bypassing additional information or context.
Conscious thinking requires effort. About 20-25% of our caloric intake is needed to simply keep our brains running.2 To conserve energy we avoid engaging our outer brain whenever possible. As a result, our reflexive inner brain is the first to assess a situation or process information and can often trump logic.
Researchers found that the anticipation of financial reward lights up the same pleasure centers in the inner brain as when experiencing other pleasurable activities like eating a good meal. It’s this experience that may override logic and reason.
Many emotional responses can be overt and easy to spot. They can also be subtle, clouding our behavior and thinking.
As a trader, balancing caution with confidence and taking calculated risks are critical to a successful trading plan. However, your experience with that plan, good or bad, may slide you suddenly or gradually to one side of the spectrum or the other. Caution has the potential to spiral into fear, or confidence morph into greed or invincibility. When the emotional balance is skewed, it can have a great effect on trading decisions in a less than optimal way.
Research shows that we often don’t think in terms of wealth, but in terms of potential gains and losses. We feel the pain of a loss approximately twice as much as the joy of a gain. We also tend to take more risk when choosing between losses and take less risk when choosing between gains.
The following experiment explores people’s tendency to seek more risk when faced with a loss.
$20 Bill Auction Exercise3
A group of approximately 10 to 20 people are asked to participate in an auction to purchase a $20 bill. The highest bidder wins the $20 bill. However, the second highest bidder not only doesn’t get the $20 bill, but is required to pay the amount of their losing bid. The bidding starts at $1 and bids are made in dollar increments.
As the auction progresses someone bids $18, but then is outbid by someone at $19. Now, the previous bidder has a choice to make; he can take the $18 loss or he can bid $20 and break even. He chooses to bid $20 and break even.
The previous bidder now has to choose between taking a $19 loss or paying $21 for the $20 bill. In most exercises, the bidders keep bidding until one of them gives in and accepts his loss which usually ends somewhere well north of $20.
Logic would dictate that the two remaining bidders would stop the bidding at or close to the $20 mark. However, when they reach close to $20, the bidders begin to focus more on the loss of the most recent bid rather the over-arching factors that will cause them greater losses if they continue. The fear of loss eventually turns the auction into a game of who will incur the smaller loss.
Similarly, traders don’t often think in terms of their overall realized gains but rather focus on the gain or loss of a particular trade. They’re reluctant to close out the trade at loss, but not doing so can be costly.
Consistently successful traders understand that losses are a regular and normal part of trading. They are aware that the goal isn’t to avoid losses at all costs—the goal is to manage their wins and losses so they work together.
The ability to make good decisions requires both a basic knowledge of subjects and understanding our knowledge limitations. Not admitting to and exploring what we don’t know leaves the door open for overconfidence, often leading to sub-optimal trading decisions.
People often overestimate their knowledge, even on topics for which they are familiar. Researchers, investigating how overconfidence was contributing to persistent and costly problems in various industries, created a confidence quiz to help measure people’s understanding of knowledge limitations.4
The participants were asked questions specific to their industry. They were instructed to give an answer range where they were 90 to 95% certain the correct answer was contained within the range. They found that even among highly skilled, highly educated professionals, none of them came close to the ideal percentage determined at the outset of the quiz.
Having an understanding and appreciation for what you don't know and exploring it—rather than ignoring it—could help keep your overconfidence in check.
Consistently successful traders understand that emotions are a potential hurdle to overcome, rather than an insurmountable obstacle. They're aware of their emotions by continually asking themselves what is making them want to start or stop an action. If they can't reasonably justify their trading decisions, then their emotions may be in charge, not their logic.
1. TVERSKY, Amos, and Daniel KAHNEMAN, 1974. Judgment under uncertainty: Heuristics and biases. Science, 185(4157), 1124–1131.
KAHNEMAN, Daniel, and Amos TVERSKY, 1979. Prospect theory: An analysis of decision under risk. Econometrica, 47(2), 263–292.
TVERSKY, Amos, and Daniel KAHNEMAN, 1981. The framing of decisions and the psychology of choice. Science, 211(4481), 453–458.
TVERSKY, Amos, and Daniel KAHNEMAN, 1992. Advances in prospect theory: Cumulative representation of uncertainty. Journal of Risk and Uncertainty, 5(4), 297–323.
KAHNEMAN, Daniel, and Amos TVERSKY, 2000. Choices, Values, and Frames. Cambridge University Press.
2. FERIS, Jabr, 2012. Does Thinking Really Hard Burn More Calories? Scientific American. July 18, 2012.
3. SHUBIK, Martin, 1971. The Dollar Auction Game: A Paradox in Noncooperative Behavior and Escalation. The Journal of Conflict Resolution, Volume 15, Issue 1, 109-111.
4. RUSSO, J. Edward, and Paul JH SCHOEMAKER, 1999. Managing Overconfidence. Sloan Management Review Reprint Series. Winter 1992, Vol. 33, Number 2.