Sorry!! The article you are trying to read is not available now.
Thank you very much;
you're only a step away from
downloading your reports.

Trading Lessons: Learn to Leverage Your Risk Aversion


Why do we cut winning positions short, and let losing positions run?

Editor's Note: The following was posted in real time on our premium Buzz & Banter (click for a free trial). It's being shared here for the benefit of the Minyanville community.

Thanks to Professor Kostohryz for his insightful Trading Update (recent highlights have included USO, Freeport McMoRan (FCX), Apple (AAPL), Palm (PALM), and SDS), and for bringing up the fascinating, complex and controversial topic of risk aversion.

The Dutch-Swiss mathematician Daniel Bernoulli is credited with introducing the concept of "utility" (sometimes called "maximum utility") to the area of decision-making. Sometime around 1783, he distinguished between the price of something and its usefulness or utility. Bernoulli concluded that value is based on utility, not price. The more money a person had, the less utility he or she gained with each incremental dollar of profit.

The implication of Bernoulli's concept is that people are fundamentally risk-averse -- i.e., they prefer certain to uncertain prospects of equal-weighted value. For example, most people, given the option of a sure gain of $20 or a coin flip where they stand to win $40 if the coin comes up tails (and nothing if it comes up heads), will take the $20.

Kahneman and Tversky provided compelling evidence against the theory of maximum utility. Their Nobel Prize-winning work on prospect theory focused on individual psychology and how gambles (like the coin toss above) were stated or "framed." Their demonstrations that psychological framing trumped maximal utility led to more modern ways of defining decision-making under conditions of risk.

At its most simplistic level, utility theory states that people are generally risk-averse; prospect theory explains that risk-aversion is more related to the psychology of how the risk is framed, i.e., how a person perceives the risk. For example:

Which of the following do you prefer?

1. A gamble with an 80% chance of winning $4,000 and a 20% chance of winning nothing, or

2. A sure gain of $3,000.

When the gamble is framed as a gain, most people prefer (2) to the risky gamble in (1). In other words, they are risk-averse in the realm of gains.

Contrast the gamble above with this one:

Which of the following do you prefer?

1. A gamble with an 80% chance of losing $4,000 and a 20% chance of losing nothing, or

2. A sure loss of $3,000.

This is a gamble framed as a loss. In this instance, most people chose the risky gamble (1) over the certain loss (2). In other words, they are risk-taking in the realm of losses.

Here is one more to think about. Which of the following would you prefer?

1. A sure loss of $30,000 or

2. An 80% risk of losing $40,000.

The results of this gamble posed to traders showed that more than 70% of them preferred (2), the risky alternative. Despite the fact that many tested here were experienced market participants, they chose the risky gamble over the sure loss. Once again, they were risk-taking with regard to losses.

The examples above simply scratch the surface of the concept of utility. Minyans may wish to slog through the St. Petersburg Paradox -- or veg out watching the TV show Deal Or No Deal -- to gain more insight. What is of practical interest is that within this framing concept lie some fundamental truths about the critical role of the human brain and psychology in making trading decisions.

At its basic level, it may shed light on the psychological underpinnings of a critical trading error -- the tendency to cut winning positions short, and let losing positions run.
< Previous
  • 1
Next >
No positions in stocks mentioned.
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

Copyright 2011 Minyanville Media, Inc. All Rights Reserved.
Featured Videos