Dr. Richard Peterson, in a recent post, provided an excellent example of the endowment effect: how we lose our objectivity once we take ownership of an asset. He brought pens to a seminar, but only had enough for half the audience. He then asked the group that received the pens to indicate how much they'd be willing to sell them to those who did not receive them. He also asked the group without pens how much they'd be willing to spend for one of the pens. The audience members without pens were willing to spend an average of $1.35 for a pen (which is close to the pen's intrinsic value), but the members who received pens insisted on a selling price averaging $8.80.
Once the audience members owned the pens and considered them their own, they systematically overvalued the pens' worth. Similarly, once we take a position in the market, it becomes *our* position and we value it simply because we have made it our own. That makes it extremely difficult to take a loss on our position, even when that is what our trading plans call for.
It's a bit like houses in the current weak housing market: many owners are unwilling to reduce the selling prices of their properties because they value their homes too much. Once we own the asset, it can own us by coloring our perceptions and actions.
I've noticed over the years that, when I'm trading well, my eye is on the stop-loss points for my positions, not on the potential price targets and profits. Explicitly spelling out how much I'm willing to lose on an idea and then staying focused on that scenario forces me to accept the possibility of loss, rather than fight it. It is a psychological trick that keeps me from getting married to my idea. By the time I put the position on, I'm already mentally prepared for it to fail.
That might sound like twisted logic to some: how can you feel confident about trading if your focus is on losing? But confidence doesn't simply come from winning; it comes from knowing that you can handle losing. By embracing the possibility of loss, we make sure that when we own a position, it won't end up owning us.
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5 comments:
I am not at all certain that this is a good example.
Value is often subjective and based on the context of a specific situation.
A thirsty man in the desert may pledge his fortune for a gallon of water required to survive.
A less extreme example: One who is attending a seminar and wishes to take notes may find that given the context, the pen is worth a premium, as giving it up requires giving up more than just the pen, but the ability to take notes and get full value out of the seminar. That may or may not have been the issue here.
Regardless, I often find these behavioral studies that prove irrational behavior seem to suffer from similar flaws. They ignore the fact that in the real world, value is often contextual and subjective.
Hello Brett, I agree with your point, to magnify a germane point that I made in my November random thoughts page on our site,(I would like to write a follow up article on it) was, Quote "First, you must conquer the fear of losing, only then can you conquer the fear of winning". This is one of the specfic points that I am working on in my trading currently. The ability to maximize good trade location by not being afraid of having patience and making larger profits. So far so good, but I can say in the past their has been some issues with the fear of winning! Thanks for your help, Best, Steve ~SSK~
Dr Brett
Great post
While it might sound like twisted logic to some, neophytes, can bypass years of pain and suffering by really understanding and adopting that approach.
Twenty years ago I was constantly amazed by the attitude, a pro blackjack player I knew, took towards his wins (and losses)
Total indifference to both. He told me that I would continue to struggle until I understood exactly what informed his utter indifference and that simply toughing it out and "pretending" to be unaffected was not enough.
His prophecy was accurate:)
Hi Nathanael,
I totally agree; for any given individual, there are highly idiographic factors behind value. When you see systematic and significant differences in valuing across individuals, then there's more at work--
Brett
Great point, Steve: the fear of losing gains can be as great as the fear of losing one's capital--
Brett
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