Page 464 - THE MARKET WHISPERER

460 PART 14 - The Demons Are Coming!

Let me demonstrate the illogic of the individuals comprising the
market by presenting the results of research conducted by Nobel laureate
psychologists Dan Kahneman and Amos Tversky, who examined the
willingness of individuals to take risks.

A group of people being studied were asked to choose from the following
two options:

(a) Gambling on an 80% risk of earning $4,000 with a 20% risk of not
earning anything

(b) An assured income of $3,000

What would you choose? Kahneman and Tversky’s research
unequivocally found that despite the financial logic of choosing option (a),
when faced with a choice of assured income, four out of five participants in
the research group chose option (b) as best suited to them.

Now let’s look at the results when the research group faces the following
options:

(a) Gambling on an 80% risk of losing $4,000 and a 20% risk of not
losing at all

(b) Losing a known sum of $3,000
Here, the overwhelming majority in the research group, being nine of
every ten research participants, preferred option (a) to take the risk rather
than absorbing an assured loss.
The parallel behavior of investors in the stock market has been
familiar to me for a long time now. One of the greatest mistakes made
by beginning traders is their cognitive inability to exit a losing trade at
their predetermined stop point. They prefer to gamble on the stock price
recovering to the purchase price rather than take the loss. They even tend
to double their investment when they see a larger than expected loss. In
professional jargon, they “average down.” When the market is moving in
the opposite direction, trending up, they tend to realize profits earlier than
necessary and make do with a safe profit rather than wait for the larger
profit.

Summary

The question each of us must ask ourselves as a trader or investor is: “Can
I adapt myself, my behavior and my thoughts to those of the market?” The
majority of people answer “yes,” but unsurprisingly the majority, as usual,
is wrong.