A Turtle Master's Insights on the Art of the Trade

Irrational investors and traders make it possible for master traders to make money. So if you want to improve your trading, it helps to understand the predictable ways that other traders may act, and what makes them act that way. Jonah Lehrer has an interesting blog post on the neurological basis for the cognitive bias of Loss Aversion. He states:

Loss aversion also explains one of the most common investing mistakes: investors evaluating their stock portfolio are most likely to sell stocks that have increased in value. Unfortunately, this means that they end up holding on to their depreciating stocks. Over the long term, this strategy is exceedingly foolish, since it ultimately leads to a portfolio composed entirely of shares that are losing money. (A study by Terrance Odean, an economist at UC-Berkeley, found that the stocks investors sold outperformed the stocks they didn’t sell by 3.4 percent). Even professional money managers are vulnerable to this bias, and tend to hold losing stocks twice as long as winning stocks. Why do investors do this? Because they are afraid to take a loss⎯it feels bad⎯and selling shares that have decreased in value makes the loss tangible. We try to postpone the pain for as long as possible. The end result is more losses.

The whole post is worth a read as Jonah goes on to provide some evidence that this human bias has a basis in physical brain function.

An understanding the motivations of other traders can be an important source for confidence in your trading strategies. If these strategies are based on ideas which, in turn, rely on the innate irrational behaviors of humans, they are more likely to continue to work over time.

{ 0 comments }