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"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

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. 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.

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:

When 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

Steven J. Hendlin, Ph.D. is a clinical psychologist in Irvine, Calif. He has been in private practice for the last 26 years, investing for the last 20 years, and actively trading online as a position trader and long-term investor since 1996. He is the author of

The Disciplined Online Investor and maintains a site at www.hendlin.net. He is pleased to receive your comments and questions for publication in his public forum columns at

steven.hendlin@thestreet.com, but please remember that he is unable to provide personal counseling or psychotherapy through the mail.

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