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.
Trading From Your Gut
Way of the Turtle
Inside the Mind of the Turtles
{ 3 comments… read them below or add one }
This is right on, and one of the things I had to learn to start doing well, but it seems I have to keep learning it — a hard one.
But this is also a question of balance. Too many times I’ve sold too soon as well — investing in a good stock that has a bad couple days, and then not bought back in quick enough when the rise re-appears to have done better than just holding through the dip. The more nervous the markets the faster this seems to happen.
What I’ve found that this article also validates, is that trading just a few issues (perhaps 5-10 at most) means that if you pick them right, they are not so widely traded by random players that it becomes more like poker — in the absence of cheating we all get random cards, and you are really playing the other people at the table. This can’t work with a widely traded stock, say GOOG and certainly not BOA or CITI, but does work well with more niche stocks (FCX, ANR, BTE, PBR) — still liquid enough, but not as widely known. The predictability of the other traders in those can give one quite an edge.
Found your book today at B&N. I had read other “Turtle” books so I was surprised that your book actually made a great deal of sense, as compared to the others.
Your life story was more enlightening than just the Turtle years. Best of luck with this book.
Having tried investing with little money and no education 5 years ago, I have experienced clear examples of selling winners and holding on to losers.
I am glad to say that the early years, call it fait, did not last and I lost interest. I am now building interest again … though this time I believe my approach is sounder.
I have started with learning – get this right and the rest will follow.
Thank you for a wonderful article, I believe you made mention of this problem in your first book. This article is great reminder.