Aug

13

Risk Aversion is the central assumption for expected behaviour of market participants. Loss Aversion is considered an anomalous behaviour. However the pursuit of any enterprise including trading and investing is profit seeking and not loss avoiding. So, like all ideas in Economics, there is a Buddhist middle path where logical conflicts are minimized. As long as there is a reasonable tolerance for losses, risk aversion works.

Within expected, expectable, tolerable, reasonable ranges of losses or risks, they are inversely correlated to each other. However, at the extremes, i.e. beyond the tolerable ranges of either losses or risks, they are not negatively correlated. “Not a negative relationship”, is not necessarily a positive relationship at or beyond the extremes. It could be that beyond the extremes, there is no relationship, undefinable relationship or a positive relationship.

The whole problem is made “intellectually” consistent by seeking refuge in quantifantasizing (quantifying & fantasizing) that an investment utility curve is unique to each unique individual in the markets and that helps define and quantify what is a numerate idea of reasonable, tolerable, expectable losses or risk.

Reality is we are using some undefined or undefinable quantities. I would like to add to the Behavioural Finance Terminology, thus the term Quantillusion since Perversions don’t exist in markets is the assumption.

Beyond the tolerance point, for some there is a stop loss wherein risk-aversion starts going close to infinity. For some, risk aversion instantly reaches infinity (read undefinable) and they live with the loss making trade until the margin calls cannot be met. There are a rare few for whom Loss Aversion and Risk Aversion are positively related in the zone of fat tails. Such rare men and women have gone to a point of no return to win yet unknown lands, discover yet not known molecules, find yet not imagined axioms.

The rarest of the rare among men and women thus are playing on that very infinitesimal probability where readiness to take a larger loss (losing it all, including oneself) while engaging in increasing risk still leads to a productive outcome. My question, is as traders and investors, does any one of us in the markets have that mandate?

So, loss aversion is not really an anomalous behaviour but only symptomatic of the anomaly of most people not wanting to know their own limits of excursions.

The sagacious Steve Ellison adds:

There are probably as many answers to this question [how loss aversion works] as there are market participants, but behavioral finance researchers have found that people value things they own more highly than non-owners would value the same things. In addition, Kahnemann and Tversky found that the pain of a loss is twice as intense as the pleasure of a gain of equal magnitude. These biases result in asymmetrical responses to risky investment situations. An investor who buys a stock that goes down is likely to stubbornly believe that the stock must be worth what he paid for it and hold on. Conversely, an investor who buys a stock that goes up becomes fearful that he will lose what he has gained and is likely to sell for a small profit.

By trading, I have gained a much deeper understanding of risk than I had before. I think most investors who are not professionals have a very shallow understanding of risk. They look at the long-term upward drift of the stock market and think about the potential profits. They smile and nod their heads when told about the periodic declines, but do not think carefully about how they will feel when the inevitable decline occurs. It is easy to understand the logic of dollar cost averaging, but hard to understand what it will feel like to continue putting money into the market when one's previous investments have shrunk dramatically in value.

I have become a believer in stops, not because they are intrinsically profitable, but because they allow me to keep losses small enough that I stay rational. They prevent trading mistakes from metastasizing into psychological mistakes.


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