Aligning with our psychology for investment success (the journey as well as the destination).
Simply Put – People hate losing money, more than they enjoy making money!
This is called loss aversion or Prospect Theory (psychologist Dr. Daniel Kahneman won a Nobel Memorial Prize in Economics for his work on this subject). We have designed our entire business model around this concept as it relates to strategy selection. This theory boils down to a single basic concept:
The perceived pain derived from a loss, hurts significantly more than the perceived pleasure derived from an equivalent gain.
So putting it in relevant context, earning $1000 doesn’t create nearly as much joy as the pain created by losing $1000. For most, this emotion is just natural human nature and interestingly enough is even evident in other species.
In one of our favorite books – SuperFreakonomics, the experiment conducted by Dr. Keith Chen was brought to light, about how he made monkeys understand the “utility of money” by allowing them to purchase rewards (grapes) based on gambling games. The same results occurred and the chimps were much more agitated in situations when losing grapes and the reaction was much more intense than their excitement when gaining grapes… even in games where the net result was the same amount of grapes!
It turns out that most investors (we include ourselves in this as well) react in the same way. Studies prove that we tend to exit winning positions early (to avoid losses), and hold on to losing positions longer than we should (to avoid crystallizing the reality of losing money).
It’s ironic but because of this emotional imbalance, investor are more inclined to avoid risk in a “gain scenario”, while in a “loss scenario” we are more inclined to seek it out. This amplified pain as a result of losing money significantly influences investors and INHIBITS the ability to make reasonable investment decisions.
As such, we model our portfolio based entirely on the concept of algo-based risk management. This is much easier to calculate and model with algos, and all programs in our portfolio tend to have a neutral or positive risk profile going forward where natural losses are easy to stomach and the upside matches or outweighs the downside. By doing so and understanding the way we think we are essentially helping ourselves to have better chances to succeed, by hacking our psychology and aligning ourselves with it – instead of opposing it.
This is so much more difficult in practice than in theory. We have always conceded to the demand for an aggressive strategy and we totally understand the appeal/attraction to such high returns (we feel the same emotions when assessing them). But the reality is that we have never experienced one that is either sustainable, or that investors can tolerate well through both the peaks and valleys.
This doesn’t mean the strategy itself is flawed (many suffer then immediately recover) however most of us simply can’t handle the inevitable downside risk. It has been impressed upon us, that our job is not simply to provide access to decent returns but to do so in a manner that will provide a smooth journey for an average investor and help avoid the knee-jerk reactions that are hard-wired into our psyche.
We are generally filtering out the highly aggressive strategies in an effort to avoid the “Forex One Night Stands” (i.e., where investors and capital flood in, immediately following big returns, and leave immediately following a big loss). Instead we want to foster “Forex Relationships” (where investors park their capital with a long-term perspective and become very comfortable with the risk in relation to the performance).
Don’t worry for those of you who like one night stands however; our FX Marketplace will be a good place where people can engage in Forex One Night Stands all they want, or simply build more aggressive portfolios.
This benefits all parties; our clients, IB partners, trade teams, and us as well (both as managers and investors). In order to create sustainability we need to understand the influence of our own psychology and subsequently structure our products to work in sync with it not against it.