Aligning with our psychology for investment success (the journey and the destination).

Aligning with our psychology for investment success (the journey and the destination).

August 1, 2017 Publications, Ramblings 1

Simply Put – People hate losing money, more than they enjoy making money!

This is a key pillar in our program design and strategy given that we manage funds for investors. 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). 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 (for the longest part – we includes ourselves in this category as well) react in the same way. Studies prove that both investors and active traders 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 strive to 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 portfolios tend to have a neutral or positive risk profile  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. Stress and panic take a strong hold.

It has been impressed upon us from a manager perspective, 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 up and down 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 educated, and 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 (be safe and use protection – equity stop loss tools we mean of course), or simply build more aggressive portfolios.

This approach benefits all parties; investors, IB partners, trade teams, and us as well (both as managers and investors). In order to create sustainability we need to all understand the influence of our own psychology as it relates to our investments, and subsequently structure our products to work in sync with this, not against it. The more we can both understand this concept, and align ourselves with it, the better chances we all have for long-term financial success.

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wpadmin:

1 Comment

  1. Neil

    April 17, 2018
    Reply

    Great article and very true. I always cut my losses to early, as I am just so happy to bank a profit.

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