Janice Dorn, MD, PhD
Neuropsychological Trading Coach
Janice Dorn, M.D., Ph.D., has been a full-time futures trader since 1994. Doctor Janice holds an M.D. in psychiatry and is board-certified by the American Board of Psychiatry and Neurology in general psychiatry and addiction psychiatry. She holds a Ph.D. in brain anatomy. A graduate of Coach University, she is a pioneer market psychiatrist and financial neurobehaviorist. Doctor Janice has written over 500 articles on the financial markets and coached over 600 traders worldwide. She is the Global Risk Strategist for Ingenieux Wealth Management Group, Sydney, Australia.
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One day Alice came to a fork in the road and saw a Cheshire cat in a tree. "Which road do I take?" she asked. "Where do you want to go?" was his response. "I don't know," Alice answered. "Then," said the cat, "it doesn't matter."…Lewis Carroll
In the Trading Wisdom titled Exquisite Risk: Part 2 of Many, I posed two separate situations that involved making a real decision about real money. I also stated that I would elaborate on the backdrop to these questions and their outcomes in the real world of trading.
You may recall that these questions were based on the 2003 Nobel Prize-winning work of Daniel Kahneman and Amos Tversky that elaborated the concept of prospect theory. Prospect theory, although somewhat complex in its mathematical derivation, is pretty simple when it is applied to the way traders and investors think. As with other simple concepts, it is quite powerful, because it affects the way we make decisions about money. Stated another way, prospect theory helps us understand why and when we take certain risks. Thus, it fits nicely into the framework of this series on exquisite risk.
To put things into better perspective, we look again to history—this time to 1738 and a Swiss mathematician and physicist named Daniel Bernoulli. Bernoulli was the first person to introduce the concept of “utility” to the area of decision-making. In doing so, he differentiated between the price of something (which is pretty much the same for everyone) and the usefulness or utility of something (which is highly dependent on individual factors). In essence, Bernoulli observed that the value of something is based not on its price, but on its utility. For example, a gain of $15,000 is more important to a poor person than it is to a wealthy person. The richer a given trader or investor, the less utility he/she gains with each incremental dollar of profit.
The implication of this is that people are fundamentally risk-averse—i.e., they prefer certain to uncertain prospects of equal-weighted value. For example, most people, given the option of either a guaranteed gain of $20 or a flip of the coin where they stand to win $40 if the coin comes up tails and nothing if the coin comes ups heads, will take the $20.
Bernoulli’s concept of utility forms the basis of all decision-making theories that are based on the notion that people maximize value (utility). There is much more to this concept, because we need to go further into real situations of trading where monies are at risk and ask ourselves how to maximize utility in the face of an uncertain environment. There will be time in future Trading Wisdoms to address this concept, which falls under the rubric of what is called “expected utility.” For now, let's stick with the basics in order to begin to appreciate what actually happens when we make real decisions about real money.
Now, let's fast-forward to the work of Kahneman and Tversky because they provided compelling evidence against the theory of maximum utility. Their prospect theory revealed the importance of individual psychology and the way that gambles like the coin toss mentioned above were stated or “framed.” Their Nobel Prize work showed that psychological framing trumped maximal utility, and led to more modern and complex methods of defining decision-making under conditions of risk. Simply stated, utility theory states that people are generally risk-averse; prospect theory explains that risk-aversion is more related to the psychology of how the risk is framed, i.e., how a person perceives the risk.
With this abbreviated background, we can now look at the questions posed in Exquisite Risk: Part 2 of Many. You may recall, they were as follows:
Which of the following do you prefer?
- A gamble with an 80% chance to win $4,000 and a 20% chance to win nothing; or
- A sure gain of $3,000.
This is a gamble that is framed as a gain, and most people prefer the gain (2) to the risky gamble (1). In other words, they are risk-averse in the realm of gains.
Contrast the gamble above with this one:
Which of the following do you prefer?
- A gamble with an 80% chance to lose $4,000 and a 20% chance to lose nothing; or
- A sure loss of $3,000.
This is a gamble that is framed as a loss, and the majority of people prefer the risky gamble (1) over the certain loss (2). In other words, they are risk-taking in the realm of losses.
Before I close for today, l will give you one more situation to consider, this time in the context of trading:
As a trader, are you more willing to:
- Accept a sure loss of $30,000, or
- Take an 80% risk of losing $40,000.
The results of this gamble posed to traders showed that more than 70% of them preferred the risky alternative (2). Many of the traders that responded were experienced market participants. Despite this, they chose the risky gamble over the sure loss. Once again, they were risk-taking in the realm of losses.
There is much more to be written on this topic, but I will close for now and probably leave this subject for a few weeks to allow time for this material to digest. What I want you to understand is that within this framing concept lie some fundamental truths about the critical role that psychology plays in trading decisions. This is the basis for understanding one of the most damaging and common trading errors—i.e. the tendency of traders and investors to cut winning positions short and let losing positions run.
It isn’t that they can’t see the solution. It’s that they can’t see the problem…G.K. Chesterton
Until Next Time,
Good Trading and Brain On!
Janice Dorn, M.D., Ph.D.
janice@thetradingdoctor.com
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