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EDUCATION | Oct 25 2017, 20:57

Nobel Winners explain Behavioral

Economicsin Financial Trading –
Part 1
Adinah BrownLeverate Follow
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Behavioraleconomics and its principally related twin, behavioral finance, seeks to

combine psychological theory with conventional economics and finance to provide
explanations for why people make irrational financial decisions. This year, behavioral
economist Richard Thaler won the Nobel Prize. His work in describing how we think
about money is monumental and has large implications for currency traders who are
looking for a psychological edge to beat the market. Thaler isn’t the first person to
earn the highly coveted award for contributions toward the trendy sub-field of
behavior economics. Daniel Kahneman an Israeli-American psychologist won the
award in 2002 for his paradigm-shifting work onhuman judgment and decision-
making under uncertainty. Along with Amos Tversky, Kahnemanoutlinedsome of
these psychological processes in developing prospect theory - a description of how
people choose between different options (or prospects) and how they estimate,
many times in a biased or incorrect way, the perceived likelihood of each of these
options.

Prospect theory should be considered mandatory reading for any serious currency
trader with special attention given to understanding ‘loss aversion;’ a description of
the concept where people prefer avoiding losses to acquiring equivalent gains: it's
better to not lose $5 than to gain $5.When traders close winning trades early,but
then patiently wait as long as necessary to avoid closing losing trades, this is known
as the disposition effect and it is a form of loss aversion. From novice to experienced
traders,the disposition effect is probably the most ruinous anomaly and to avoid this
effect from negatively affecting performance, behavioral economists recommend
periodically selling underperforming assets or placing stringent time limits forallowing
positionsto remain open.

Within prospect theory, another described effect applicable to currency traders is a

diminished sensitivity to gains and losses. The effect can be measured through a
‘value function’ given to gains and losses accrued from starting reference point
(please see diagram below). Diminishing sensitivity means that people's sensitivity to
further changes in gains/losses is smaller for accrued profit/loss positions that are
further away from the reference point. For example, if a currency trader over the
course of a year accrues $50,000 profit from a starting balance of $10,000, the next
$1000 profitable trade will not be ‘felt’ to be worth as much as the profitable $1000
earned at the beginning. In addition to overconfidence, this effect may explain why
successful traders get sloppy over time and deviate from refined and lucrative
strategies. Periodically renewing a commitment to a strategy and adjusting it as
necessary is a way to mitigate the bias of diminished sensitivity for gains/losses.

Basic knowledge of behavioral economics can contribute to your success as a trader

in numerous ways. As noted above, Kahneman and Tversky’s prospect theory can
contribute to better trading psychology and applicableconceptsthat can be tacked on
to existing strategies relatively easily. In part 2, I will describe how some of Thaler’s
award-winning findings can benefit even the most rookie of traders.

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All essays, research and information found above represents the analysis and opinion of Adinah Brown, financial
journalist at Leverate only. As such it may prove wrong and be a subject to change without notice. Opinions and
analysis were based on data available to the author of her respective essays at the time of writing. Although the
information provided above is based on careful research and sources that are believed to be accurate, Adinah Brown
does not guarantee the accuracy or thoroughness of the data or information reported. The opinions published above are
neither an offer nor a recommendation to purchase or sell any securities. Adinah Brown is not a Registered Securities
Advisor. By reading Adinah Brown’s reports you fully agree that she will not be held responsible or liable for any
decisions you make regarding any information provided in these reports. Investment trading and speculation in any
financial markets may involve risk of loss.
RELATED TOPICS

 Psychology

 MoneyManagement

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