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Psychology vs Probability

>> Tuesday, November 17, 2009

When investing, ever wondered why most people take small profits instead of letting profits run and hold on to huge paper losses instead of taking a small loss early?

A lot has to do with the human psychology towards money. Our rational mind knows probability, but our sub conscious mind knows emotions like fear and greed. Which one prevails will determine your approach to investing and your overall success.

Which would you choose:
Option 1: A sure win $700 bet
Option 2: A bet for 75% chance for $1000 with a 25% chance of losing everything

If psychology of fear prevails, you will take the $700 bet because it means assured immediate profits in the pocket. However, the rational mind knows the probability of the expected outcome for option 2 is $750, a potentially better outcome.

Another choice:
Option 1: A sure lose $200 bet
Option 2: A bet for 75% chance to lose nothing with a 25% chance to lose $1000

If psychology of greed prevails, you will take the bet to lose nothing as the chances looks stacked in your favor. However, the rational mind knows the probability of the expected outcome for option 2 is a loss of $250, a potentially worse outcome.

From these 2 simple illustrations, the first one explains why most take profit too early instead of allowing their profits to increase further; the second one explains why most hold on to losses, hoping for a recovery instead of cutting losses.

Investing involves risk, risk is about probability. Hence, it is more sound to approach investing with a rational mind. Letting the emotional mind to control investment decisions complicates matters because investing has no relationship to emotions.

This first step of learning to invest is often neglected. However, it is the most important step. If you frequently encountered situations where prices move higher when you took profits and prices move lower while you hope they recover, it is time to reexamine your psychology towards investing.

I know, i know, it is easier said than done... Well, who said investing was easy.

2 comments:

la papillion November 19, 2009 at 10:22 PM  

For the first question, my choice is 1. For your 2nd question, my choice is still 1. I reasoned that a sure win or sure loss is better than the uncertainty of waiting for one.

If there's only 1 chance, knowing the expected outcome is of no use, since that's the weighted average of many many trials. If you only have 1 trial, one chance, I'll choose the sure bet and move on to the next one.

Lau November 19, 2009 at 10:55 PM  

Thanks for your comment support.

Your reasoning is sound and it can be your strategy. It is a very rationale, emotionally detached choice. The exact mentality a professional trader should adopt.

The scenario illustrated may be too simplistic with only one standalone situation with clearly defined numbers.

However, imagine now that you are already invested with your real money today.

outcome after 1 day: move up 1%. sure bet, take profit now. wait 1 more day, it may go back down 1%.

outcome after 1 day: move down 1%. sure bet, lose now. wait 1 more day, it may recover back 1%.

if you choose to hold, the outcome may affect your emotions and you are faced with the decision the next day and so on.

so is the decision based on feelings:
1. I HOPE it will go up more.
2. I FEEL it is already too high.

or based on mechanical money management techniques:
1. A pre-determined target profit strategy.
2. A pre-determined stop loss strategy.

hope it changes your perspective of what the choices are illustrating.

Also consider. Investing is all about uncertainty. To only take the sure bet, it is for the risk adverse, probably only into fixed deposits.

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