Humans have several psychological tendancies that when exposed to the machinations of the financial markets, result in sub-par performance.

The first one that needs exposure is the tendancy of human psychology operate in the following aberrant fashion. Human psychology does not operate to maximise gain rather it operates to maximise the chance of gain.

This subtle difference thus generates the following manifestations of pathology within the trader. First, losses become the subject of a gamble. As a loss is a bad outcome, holding on “a little longer” might see the trade profit or breakeven. Thus is discipline very slowly eroded. Eventually, a career threatening loss might be the ultimate result.

Second, wins are taken quickly. The old Wall St adage of “you will never go broke taking a profit” is offered up as empirical evidence. I have actually observed this very quote earlier in the week with these exact sentiments being echoed by none other than flip-flop-fly.

Mr Market conditions unwary participants to this very pathological reflex behaviour through the following mechanisms. Price tends to cycle through repeated areas, thus engendering the psychological response of anchoring. Here, the trader links the current price as normal, and a large move as aberrant.

The result is sadly predictable. If facing a loss, the belief of exiting at a small profit or breakeven, tempts the trader to take the gamble of a small win, against a known loss, or conversely, to take a small known profit, against the gamble of a larger win.

This tendancy has been well documentated within the “Behavioural Finance” literature. The correct behaviour actually requires obviously first recognition of the problem, and second, understanding the nature of timeframes in the formation of the pathological reflex. This will be addressed next weekend. Until then, good trading.

Smoke rings
Mr Romulus.

Advertisements