Watering The Weeds

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

The behavioral approach to making trading decisions is relatively new. In essence, it began with the Nobel Prize winning work on Prospect Theory of psychologists Daniel Kahneman and Amos Twersky. (Kahneman won the Nobel Prize in 2002, six years after Twersky's death. The Nobel Prize is not awarded posthumously)

Prospect theory is grounded in the concept that, when making decisions, people rely too heavily on framing, anchoring and the disposition effect. Because there are so many trading and investing lessons embedded within Prospect Theory, it is helpful to review some aspects of it.

One such aspect is called loss aversion. 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. On paper, your portfolio is 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.

This concept 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. In an experiment, 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 that 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 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 (new) brain that we have a chance to make up for a loss, we will hold on. However, if the emotional (old) 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, leading to a cycle of catastrophic thoughts of further losses and financial ruin. This leads to more panic-selling as tension and anxiety 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 traders who watch their profit and loss multiple times 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, I urge you to go back over your trading journal for the past month 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.

The reason you are watering weeds and cutting down flowers lies squarely within your brain. If you aware, you are on the path to understanding and profiting.

You can't be afraid to take a loss. The people who are successful in this business are willing to lose money...Jack Schwager

Janice Dorn, M.D., Ph.D.