Sunday, 6 January 2013


An oft cited study offered subjects two options. Option 1 was that a coin toss of Head would result in a win of $100 while a Tail meant nothing, while Option 2 gave the subject $100 up front, with a Head meaning the subject keep it, and a Tail meaning he give it back. Identical outcomes of course, but more people favoured option 1, evidence that "the pain of losing a dollar is far more powerful than the pleasure of winning a dollar". (More people switch insurance companies if their company raises rates, than if a rival company reduces rates). Incidentally, when trying the experiment on Mrs Cassini, she replied that she would choose option 2. To her credit, she recognised that the options were the same, but claimed that if she lost, she would refuse to give the money back! I sometimes feel my research isn't given the respect it deserves.

The bottom line is that loss aversion causes people to make suboptimal choices. Scorecasting - The Hidden Influences Behind How Sports Are Played And Games Are Won - is some Christmas reading that gives a number of examples of how this influences coaching decisions in sports such as American Football, basketball, baseball and ice hockey. Coaches would be better served statistically by (respectively) "going for it" on fourth down, not benching players after five personal fouls, using the closer earlier and pulling the goalkeeper earlier, but even when made aware of the benefits of these strategies, most choose to follow conventional wisdom. Why? Most would rather lose games by following convention, than risk losing a game by trying something non-conventional, figuring that their jobs were less likely to be lost with the traditional approach. The coaches most likely to adopt the optimal strategies are those 'tenured' coaches, such as Bill Belichick of the New England Patriots. The book contains the story that one NBA coach was presented with the evidence, yet insisted he would follow the sub-optimal convention of benching his player. Asked why, he replied "Because my kids go to school here!"

This rather backs up my assertion that optimal decisions can only be made when you are free of pressure. For traders, it's all too easy to take the sub-optimal guaranteed small profit option of greening up too early, without realising that in the long run, this is costing you profits. If you need that £100 to put food on the table, you will be less likely to let it run, even if this is the optimal play, telling yourself that no one ever went broke by taking a profit. Perhaps not, but not many will get rich by making sub-optimal plays all the time.

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