Janice Dorn, MD, PhD
Neuropsychological Trading Coach
Janice Dorn, M.D., Ph.D., has been a full-time futures trader since 1994. Doctor Janice holds an M.D. in psychiatry and is board-certified by the American Board of Psychiatry and Neurology in general psychiatry and addiction psychiatry. She holds a Ph.D. in brain anatomy. A graduate of Coach University, she is a pioneer market psychiatrist and financial neurobehaviorist. Doctor Janice has written over 500 articles on the financial markets and coached over 600 traders worldwide. She is the Global Risk Strategist for Ingenieux Wealth Management Group, Sydney, Australia.
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Selling stocks that are doing well and buying ones that are doing poorly is like watering the weeds and cutting down the flowers…Peter Lynch
This week, we return to the burgeoning and often confounding world of behavioral neurofinance. A reminder for you today is that this is part of an ongoing education in the principles of behavioral neurofinance. My intent, as expressed earlier this year, is to gradually introduce you to this subject and build on what you have learned to move into a better grasp of how your trading behaviors are influenced by your thinking biases. I encourage you to learn a little about this subject every day, and not try to grasp it all at once. As time passes, it will begin to make sense to you. You will see your trading and investing decisions in an entirely different light.
As you may recall from previous Trading Wisdoms, the behavioral approach to making trading decisions is relatively new. In essence, it began with the Nobel Prize winning work of the famed economist Daniel Kahneman. Kahneman won the Nobel Prize in 2002 for his work regarding prospect theory. Prospect theory is grounded in the concept that, in the face of decision-making, people rely too heavily on framing, anchoring and the disposition effect. A complete analysis of prospect theory is far beyond the scope of this piece. However, there are so many trading and investing lessons embedded within the theory that we are advised to heed them and learn as much as we can about certain aspects of it.
One of the most critical aspects for Trending123 subscribers is the concept of loss aversion. Loss aversion explains why traders overweight losses about 2.5 times more than they do gains. Here is an example of how loss aversion is processed in the brain: You have four equally weighted positions in your portfolio. Two are up 10% each, and two are down 10% each. Your portfolio, on paper, is a breakeven. Nonetheless, you feel like you are losing. In fact, you feel that you are actually down 25%! This is because losses are processed in the rat brain with an intensity of 2.5 times that of wins.
There have been volumes written about loss aversion, and it is not a particularly easy concept to grasp. Nonetheless, it is critical for you to understand the general concept because it explains why so many traders cut winners and let losing positions ride. Experiments have shown that "dread" causes individuals to take losses as quickly as possible. These so-called "dreaders" actually paid money so that they could experience a feared electric shock sooner. At first glance, this finding appears in total contradiction to the disposition effect, which suggests people will pay more to avoid taking losses.
So, how do we explain this seeming dichotomy? In experiments involving the disposition effect, there is always the hope that the feared loss with not occur. When this hope is shattered and the loss is seen as very real, people will actually pay more money to "just get it over with."
In the markets, because the future is uncertain, the gap between selling to relieve dread and holding because of an aversion to loss lies entirely in what the brain believes about the future. For example, if we think with our logical, rational new brain that we have a chance to make up for a loss, we will hold on. If, however, the emotional rat brain takes over, it will completely overwhelm the logical brain and we will act impulsively and quickly to get out before the pain really takes hold. To add insult to injury, fear causes large amounts of stress hormones to be released from the rat brain into the body, leading to a vicious cycle of catastrophic thoughts of further losses and financial ruin. This leads to more panic-selling as the tension and anxiety generated from the rat brain overwhelm and are too much to endure. We want out of the pain immediately and at any cost.
The disposition effect is particularly dangerous for those traders who watch their profit and loss every minute during the trading day. Such traders tend to buy and sell on price movements. When they are profitable, they are more likely to think they should take the profits because they see an uncertain future where the profits will vanish. On the other hand, when they are losing and they see their profits declining, they see the future as a chance to compensate for losses.
If all of this sounds a bit challenging or confusing to you, I urge you to go back over your trading journal for the past month (remember, all you need is a 79 cent notebook and daily discipline to keep a trading journal) and look at the times when you have done exactly what has been described in terms of taking profits too quickly and letting losers run.
This is not the end of our study of prospect theory and loss aversion, rather it is but one small sample of the most fascinating aspects of why we hold when we should fold and vice versa.
You can't be afraid to take a loss. The people who are successful in this business are willing to lose money…Jack Schwager
Until Next Time,
Good Trading and Brain On!
Janice Dorn, M.D., Ph.D.
janice@thetradingdoctor.com
P.S.—Take a sneak peek at my new book, Personal Responsibility: The Power of You, published in January, 2008, at www.personalresponsibilitybook.com.
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