Shrink Rap: Trading Lessons From a Nobel Laureate

"Nothing that you're thinking about is as important as it seems when you're thinking about it."

-- Daniel Kahneman

Dear Shrink Rap:

What can investors and traders learn from the psychological work of the recent Nobel Prize winner Daniel Kahneman?

Shrink Rap: I was pleased to see a psychology professor and researcher win this most prestigious honor for his work in testing psychological assumptions with economic models. Kahneman and other behavioral economists have tried to show that people don't think or behave rationally when it comes to money decisions, despite previous economic models that hypothesized that they do.

One conclusion from Kahneman's work was that we tend to think about and focus too heavily on the short-term picture. His experiments showed that one way this happens is by thinking more in terms of short-term gain and loss than in terms of longer-term wealth.

This leads to greater risk aversion, especially after sizable losses, because studies show we give greater weight to losses than gains. (Or, it hurts more to lose than it feels good to win.)

It seems almost like Kahneman was referring to the traditional philosophical differences between short-term trading and long-term investing. This error of focusing on the shorter-term rather than the long-term accumulation of wealth is, of course, what financial planners are always harping on.

But the problem is that if we're unable to flexibly adjust our thinking to cope with sharp countertrend reversals or a shift in the major trend itself, focusing on the longer term can end up being catastrophic, as so many have learned. We must be cautious in applying Kahneman's or others' work in behavioral finance directly to trading because their conclusions must always be considered in light of both specific and intangible market variables. And when they are exposed to that light, we find no simple answers or formulas that we may apply uniformly.

Another way to put this is by invoking the common refrain of traders who become glossy-eyed when they hear too much theory from journalists, strategists and academics: "Put your money on the line, Jack, and let's see how long you stand by your theories." That said, all theories are not created equal. And those that are worthy of Nobel Prize distinction call for our attention.

Remember the Recency Effect?

Consistent with Kahneman's thinking, in a past column I pointed out a similar mental bias called the recency effect. We not only tend to focus more on recent gains and losses, but we also give more weight to them in our decision-making because we tend to remember what's most recent.