Prospect Theory

Gundulf at Betfair Football Trading took an in-depth look at one of my Sultan interview (part One) answers - the question was

What do you think are the biggest mistakes that new traders make when attempting to become successful?

and my answer was this:

A couple of mistakes come to mind, one in the preparation, the other in the execution. One is over confidence. Too many people seem to think that profitable trading is just a matter of sitting down at the PC and that somehow the funds will simply roll in. They think that in a sport like horse-racing (something I never touch by the way) they have an edge over insiders and full-time traders with years of experience. Really? Optimism is good, but so too is realism. The other is the need to let winning trades run and cut the losing trades short, whereas the tendency is to do the exact opposite.

Referring to stocks, and thus not all of the below applies, a Meir Statman (what a great name) wrote in "Investor Psychology and Market Inefficiencies"

"In summary, people trade for both cognitive and emotional reasons. They trade because they think they have information when they have nothing but noise, and they trade because trading can bring the joy of pride. Trading brings pride when decisions turn out well, but it brings regret when decisions do not turn out well. Investors try to avoid the pain of regret by avoiding the realization of losses, employing investment advisors as scapegoats, and avoiding stocks of companies with low reputations."

The topic of the pain associated with losses and the pleasure associated with gains is an interesting one. If you read up on Prospect Theory, you will come across a study by Tversky and Kahneman which in 1979

...found that contrary to expected utility theory, people placed different weights on gains and losses and on different ranges of probability. They found that individuals are much more distressed by prospective losses than they are happy by equivalent gains. Some economists have concluded that investors typically consider the loss of $1 dollar twice as painful as the pleasure received from a $1 gain. They also found that individuals will respond differently to equivalent situations depending on whether it is presented in the context of losses or gains.

Controlling the emotions that make us want to lock in that small profit and avoid a loss (regardless of whether it is value to do so) rather than let the winning trade run, is definitely one of the biggest keys to becoming a successful trader. Minimise the losses, not the wins.