Previous Research and Theory

Why does not everybody minimize losses and maximize profits?
Traditionally, economic theory is based on the idea that market
9
operators are rational and therefore make rational decisions.
Feelings and biases do not influence the operators’ judgement, only
relevant information effects their behavior. Decision-makers
decide on basis of the probability of each alternative outcome and
select the alternative giving the maximum return. This view is not
supported without exception (Sebora & Cornwall, 1995; Bell, Raifa
& Tversky, 1988).
As stated earlier, our choices are influenced by how a situation is
framed. A problem is positively framed when the options at hand
generally have a perceived probability to result in a positive
outcome. Negative framing occurs when the perceived probability
weighs over into a negative outcome scenario. In one of Kahneman
and Tversky’s (1979) experiments, the participants were to choose
one of two scenarios, a 80% possibility to win $ 4,000 and the
20% risk of not winning anything as opposed to a 100% possibility
of winning $ 3,000. Although the riskier choice had a higher
expected value ($ 4,000 x 0.8 = $ 3,200), 80% of the participants
chose the safe $ 3,000. When participants had to choose between
a 80% possibility to loose $ 4,000 and the 20% risk of not losing
anything as one scenario, and a 100% possibility of losing $ 3,000
as the other scenario, 92% of the participants picked the gambling
scenario.
This framing effect, as described in Kahneman and Tversky’s (1979)
Prospect theory, occurs because individuals over-weight losses
when they are described as definitive, as opposed to situations
where they are described as possible. This is done even though a
rational economical evaluation of the two situations lead to
identical expected value. People tend to fear losses more than they
value gains. A $ 1 loss is more painful than the pleasure of a $ 1 gain
(Kahneman & Tversky, 1991). Describing a loss as certain, and
therefore more painful, will inflict investors trying to avoid such a
loss. As a consequence, they will take a greater risk and gamble in a
losing situation, holding on to the position in hope that prices will
recover. In a winning situation the circumstances are reversed.
Investors will become risk averse and quickly take profits, not
letting profits run. This goes for the professional investment
managers as well (Olsen, 1997), and this is not only a tendency in
the Western world (Sharp & Salter, 1997).
Costs, that is, losses, made at an earlier time may predispose
decision-makers to take risks. They are more risk seeking than
they would be if they had not made the earlier loss (Zeelenberg &
van Dijk, 1997). This effect is referred to as “the sunken cost
10
effect” and results in organizations and individuals “throwing good
money after bad” in order to make up for the loss (Ghosh, 1995).
The loss already incurred makes the context equivalent of a
negative frame, but with an increased commitment, for example,
buying more shares makes a recovery possible, although uncertain.
Nothing new under the sun, especially in the markets:
. . . I did precisely the wrong thing. The cotton showed
me a loss and I kept it. The wheat showed me a profit
and I sold it out . . . . Of all speculative blunders there
are few greater than trying to average a loosing game.
Always sell what shows You a loss and keep what
shows You a profit. That was so obviously the wise
thing to do and was so well known to me that even
now I marvel at myself for doing the reverse. (Lefèvre,
1923/1993, p. 154)
Investors and traders, shifting in risk tolerance according to
positively and negatively framed situations, show no risk aversion,
but an aversion against losses. Loss aversion applies when one is
avoiding a loss even if it means accepting a higher risk (Tversky &
Kahneman, 1986). The preference for risky actions to avoid an
impending loss over less risky options just to minimize the loss and
“bite the bullet” can be explained by “loss aversion” (Thaler &
Johnson, 1990).
Weber and Camerer (1998) describe selling assets that have gained
value and keeping assets that have lost value as “Disposition effect”
in a recent experimental study. The disposition effect is based on
two characteristics of prospect theory, namely the tendency of
individuals to value gains and losses relatively a reference point and
further, the tendency to be risk-seeking in situations where a loss
might occur and risk averse in situations where a certain gain is
possible. Weber and Camerer’s study showed that participants did
sell their winners and kept their losers.
Being poor Bayesians, is that our lot, or is this disposition effect
possibly alterable? Is it conceivable adopting the behavior of the
“market wizards” or at least avoiding the most flagrant mistakes? Is
it determined by chance if one is behaving like Nick Leeson, trading
Baring’s Bank into bankruptcy, or like Michael Marcus, who went
bankrupt in the beginning of his career and later turned $30,000
into $80 millions?

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