Emotions, ignorance and trade

Sometimes ignorance can be bliss when trading in stocks. Taking long breaks from watching the stock ticker might be just what an emotionally-hyped trader needs, writes Jason Somerville

They say “ignorance is bliss” and indeed it is a phrase that is uttered too frequently. However, might it also be profitable? One of the greatest obstacles that a trader must overcome is that of human emotion. Experienced traders often warn of the dangers of becoming emotionally attached to a stock. Those who do may exasperate their losses by failing to exit a stock despite the clear warning signs.
But that doesn’t seem very rational. Homo economicus would be rolling in his fossilised grave.
What Homo economicus doesn’t understand is that emotions affect the decision-making process. While it may prove trivial for day-to-day decision-making, it can have disastrous consequences for some traders’ portfolios.
When an investor sees the value of an investment fall she experiences disappointment and regret. These emotions have a much stronger impact on a trader than the elation and rejoicing that is elicited from seeing an investment rise. Throw into the mix the anxiety associated with a financial loss and the decision-making of traders appears to be more prone to irrationality than most.
Interestingly, traders are presumed to be the most calculated of all decision-makers. After all they receive years of training in finance and economics and are frequently told to avoid irrational decision-making. Despite this, they are frequently observed succumbing to the most basic limitations of human judgment. This shouldn’t be surprising given the complex ways in which emotions affect our cognitive ability.
The “trick” then to being a good investor is that you should buy a stock and not give in to the temptation of real time prices on the Bloomberg screen. By doing so you can avoid the rollercoaster of emotion that often clouds people’s judgement. But why is it that seeing an investment fall elicits a stronger emotional response than an increase? The answer resides in the phrase “losses loom larger than gains.”
The Irish economy provides an excellent example. In the period between 1990 and 2007 Ireland experienced unprecedented economic growth. From a country once viewed as an economic liability within the Eurozone, Ireland came to be ranked as the 4th richest country in the world in 2005 in terms of Gross Domestic Product. However, the recent downturn has been so extreme that Ireland has become perceived, both at home and abroad, as a country in economic difficulty.
While the structural imbalances that have developed within the Irish economy over the past decade cannot be ignored, the reality is that Ireland is still a very wealthy country that continues to attract multi-national investment. An explanation for such biased representation is based on prospect theory which was put forward by Nobel laureate Daniel Kahneman and his associate Amos Tversky.
The most basic assertion that prospect theory makes is that economic actors place a greater value on a loss when compared to an equivocal gain. Indeed, this claim has been empirically supported. Shlomo Benartzi and Richard Thaler have suggested that this is because people display “myopic loss aversion.” In other words nearsightedness (myopia) and a tendency to place a higher value on avoiding a loss can explain why Ireland is currently perceived as an economic laggard when in fact, we are still one of the richest countries in the developed world.
If we place a greater value on losses than we do gains then it’s not surprising that when a trader sees a 20% drop in an investment they experience a greater influx of emotion when compared with a similar gain. Making decisions while heavily under the influence of emotions can lead to irrational decisions which markets have a tendency to punish.
So perhaps all those Bloomberg screens were a waste of money? Not exactly: caution is still required. One of the greatest paradoxes of the efficient market hypothesises is that a market is only efficient because inefficiency exists. Therefore the more traders endorse such rational techniques the more efficient traders will be.
The net result? Markets will be inefficient and such techniques will prove useless.