DR Barton: How to Trade Like a Nobel Prize Winner - Or Not

How to Trade Like a Nobel Prize Winner - Or Not
by D.R. Barton, Jr.
President, Trader’s U

Imagine my surprise. I was reading an article about an important trading concept. Nothing strange about that. What was unusual was that this was an academic article of a recent Nobel Prize winner.

The concept that caught my eye was this: People don't make tough decisions based on statistics. They make them based on emotions and past experiences.

So another economic myth is busted...

Busted because modern economics is based on the assumption that people make "rational" (or thoughtful) decisions in a way that will always give them the biggest reward.But the guys who wrote this dandy article on behavioral finance have exploded that myth. Daniel Kahneman won the 2002 Nobel Prize in Economics for this work, so I'm sure he's a pretty smart guy. In short, he and his co-author proved one important fact:Decision-making changes for most people when they are faced with the combination of:
Losing money, and
Uncertain results

This combination changes people from logical decision-makers to emotional decision-makers. Using emotionally charged shortcuts, or so-called "rule of thumb" guidelines, makes us pretty lousy at deciding things.

I'd have to guess that anyone who has traded stocks or commodities knows what these Nobel laureates were writing about. Because the "trading psychology" of it goes something like this:

Traders and investors love making profits. But they hate losses even more - and will go to great lengths to avoid them. Traders rationalize it in this way: "It's not a loss until I close out the position." So they hang onto little losing positions and let them turn into big losing positions.

On the other hand, traders love to make a winning trade. So they tend to take their winners very quickly instead of giving that winning position the time to turn into an even bigger winner. These are the same findings that Dr. Kahneman wrote about in his groundbreaking article.

You can avoid the decision-making mistakes that made a Nobel Prize winner famous if you follow a few simple rules.

Think Like a Trader, Not Like a Gambler
The Noble prizewinners identified three distinct decision-making problems. This week we'll look at the psychology behind these problems and how you can avoid them in your trading. Next week we'll look at some hard numbers that will give concrete examples of how you can apply these simple concepts to your trading and investing.

Adopt an attitude of indifference to losses. Think of losses as a business expense. Better yet, frame your losses as the necessary "raw materials" for your business. Framing losses in this ways has several clear benefits. You understand that losses are a required part of trading. Since losses are like any other business expense, you no longer avoid them. You just want to minimize their cost like you would the cost of raw materials. (If you never bought any raw materials, you could never make any products.)

Accept uncertainty as a part of trading. The 2002 Nobel winner found that people pay too much to avoid uncertainty. There are many areas in life where people accept uncertainty: relationships are almost always uncertain; so are fishing trips and cheering for the Boston Red Sox. In any of these endeavors, we don't know how they will end (well, except maybe with the Red Sox). It's the same with our trading. Accept that any single trade could be a win or a loss. Get out if you're wrong, and hang on if you're right. Over a large number of trades, good traders and good trading strategies will win. But for one trade, anything can happen. So don't get emotionally attached to a trade. Execute your plan and move on to the next opportunity.

Understand the Law of Small Numbers. Traders, like golfers, seem to be eternal optimists. A golfer can take 100 bad swings and still be excited to go out and play tomorrow because of one good shot. In a similar way, traders often draw broad conclusions from a ridiculously small number of data points. I wish I had a buck for every time I've heard, "That system (or newsletter or strategy) stinks - it lost three times in a row!" After tossing out the latest strategy, the optimist thought process kicks in, "There has to be something better out there!" Realize that it is impossible to draw a meaningful conclusion from a small number of data points. Three, four or even 10 occurrences are not enough to draw a conclusion in the trading world (or in any complex environment). Take the time to understand why your trading or investing strategy works and don't throw it away after a few losses. In terms of statistics, 30 trials is usually a minimum number that is needed to make any meaningful decisions.

As a trader or investor, keep your emotions in check and don't take psychological shortcuts. Let your knowledge of your investing strategy guide your decision making and you'll be on your way to beating a Nobel-sized problem that plagues traders both new and old.