Many investors are familiar with prospect theory or at least its implications on investor behavior. The pain of losses will be greater than the pleasure of gains. Hence, we hold onto our losers and sell our winners.
Another way of putting prospect theory into words is that we place extreme or higher weights on extreme events. If there is a X% chance of a negative event, many will assign a probability that is higher than the true chance of that event. Investors believe rare events will be more likely to occur. There is an over-weighting bias.
Another way of putting prospect theory into words is that we place extreme or higher weights on extreme events. If there is a X% chance of a negative event, many will assign a probability that is higher than the true chance of that event. Investors believe rare events will be more likely to occur. There is an over-weighting bias.
However, thinking about risk often gets trickier. There is a behavioral bias with how we may react when risks are described to us versus how we react when risks are experienced. If a risk is described to an investor as a possibility, we will give it a higher probability of occurring than as described. You could say our risk imagination runs wild.
However, if there are risks which we have experienced, we will give it a lower probability of occurring. This seems odd, but psychological testing seems to show this to be the case. This testing is done through having subjected experience sampling of some rare event. This reason for this behavior could be because of a recency bias. If we have not experienced a rare event, we will under-wight it. We have the view of our experiences that if it has not happened, it will not happen to us.
You would think that experienced risks of actual rare events would be given higher weight but this also is not the case. If we experience a hurricane or earthquake, we will underweight another rare event like that in the future. I don't know if this is a variation of "what does not kill me makes me stronger", but how risks are presented matters. We will underestimate experienced risks and over estimate the chance of described risks.
However, if there are risks which we have experienced, we will give it a lower probability of occurring. This seems odd, but psychological testing seems to show this to be the case. This testing is done through having subjected experience sampling of some rare event. This reason for this behavior could be because of a recency bias. If we have not experienced a rare event, we will under-wight it. We have the view of our experiences that if it has not happened, it will not happen to us.
You would think that experienced risks of actual rare events would be given higher weight but this also is not the case. If we experience a hurricane or earthquake, we will underweight another rare event like that in the future. I don't know if this is a variation of "what does not kill me makes me stronger", but how risks are presented matters. We will underestimate experienced risks and over estimate the chance of described risks.
Think of how this will effect and bias traders. Decision-makers will follow the concepts of prospect theory for described risks, but will follow the opposite behavior for experienced risks. So what happens if we have both experienced rare events and have them described? We will show tendency to have some weighting of experience and description.
This is another reason for systematic trading. If we will change our behavior with changes in our experiences, we cannot control our decision-making. If we change our behavior when new risks are described, we also cannot control our behavior.We need to impose good behavior upon ourselves.
This is another reason for systematic trading. If we will change our behavior with changes in our experiences, we cannot control our decision-making. If we change our behavior when new risks are described, we also cannot control our behavior.We need to impose good behavior upon ourselves.
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