Shrink Rap: Trading Lessons From a Nobel Laureate

The implication for trading is that if you have suffered moderate to heavy losses, those losses will become more significant in your decision-making than the thought of future gains. Not surprising, you become more averse to risk.

This is exactly what three years of bear claws have done to the psyches of investors, many of whom once focused more on the longer term, but got clobbered adhering to that mentality. Some of them will be lost forever, while others are building back their capital and may come back when the market and the geopolitical scene appear more stable.

Because they are more risk aversive, those looking to return will be less trusting of a definitive change in the trend when it occurs, regardless of the technical or fundamental indicators. Fortunately, there's no need for still-shellshocked investors to jump in, as a change in trend will allow them plenty of time to wade back into the water. For the added protection, they are more than willing to sacrifice a portion of the early gains.

On the Flip Side: Overconfidence

There's also the flip side of becoming too risk aversive: Kahneman found something he called the "illusion of validity." As it pertains to trading, it suggests that traders tend to become overconfident in their own beliefs and plans. This leads to taking too much risk, as well as to overtrading.

This is one of the errors of some swing and, especially, intraday traders who are looking to bolster their own thinking and confidence in the face of so many other contrary opinions and, often, conflicting data.

Wanting to feel confident enough to initiate a trade or hold a position taken without wavering, they may fall into overconfidence. They think they can't be wrong. They become stubborn, holding positions too long and believing that they'll be proven right if only they hang in there.

When he talks about overconfidence, Kahneman sounds something like a technical trader discussing the need to measure risk and always be thinking defensively. To conclude, let me quote him directly, as he distinguishes between confidence and overconfidence:

[W]hen you are executing, not to be asking yourself at every moment in time whether you will succeed or not is certainly a good thing. ... In many cases, what looks like risk-taking is not courage at all, it's just unrealistic optimism. Courage is willingness to take the risk once you know the odds. Optimistic overconfidence means you are taking the risk because you don't know the odds. It's a big difference.

-- From "Nobel Laureate Debunks Economic Theory," Forbes.com, Nov. 6, 2002