When the ideas of classical finance were developed in the 1950's economists assumed that people behaved in a purely rational way, resulting in perfectly efficient markets. Over time many apparent anomalies in this theory were discovered. But these were easily dismissed by the academic establishment as irrelevant, statistically insignificant or explainable through some combination of risk factors. Crucially nobody was able to come up with an alternative model that was as self consistent and elegant as the efficient markets hypothesis.
From the 1980's onwards the field was penetrated by academics from the discipline of psychology. For these experts in the human mind the economist's framework of pure rationalism must have been highly amusing. A key insight these interlopers brought in was that our brains are loaded with baggage from our distant past.
Parts of our grey matter are still hardwired for survival in a hostile environment where quick thinking was better than slow thoughtful consideration. As a result we have deep rooted instinctive behavior that makes it extremely difficult to behave in the rational way that classical finance expects. The new field that the interlopers created was behavioral finance,and it did have its own unifying model
rospect theory.
Prospect theory explains why investors behave irrationally when confronted with certain trading decisions, such as whether to sell out of a position which is now showing a loss. Most people show the greatest reluctance to take losses, as I did in 2010 with BP. Conversely if the position has risen in value they are happy to take profits and sell quickly, as in my 2004 BP trade.
The former situation has been catchily described as “get-evenitis” by Hersh Shefrin. This aversion to taking losses is a very powerful instinct. Humans do not seem to view a paper loss as real until it has been crystallised, so we can postpone the painful feeling of losing money. We are also reluctant to admit that we made a mistake with our initial purchase. Selling is an admission of failure.
The main motivation behind selling positions at a small profit appears to be to minimise regret. If the stock fell back after reaching a new high we would castigate ourselves for not taking profits earlier.
Both of these effects are at odds with classical theory,which states that peoples actions and preferences for risk are unrelated to whether they have made paper profits or losses. In contrast prospect theory says we take more risks in a losing position to get even. But we want less risk when winning, preferring a certain gain to a chance of losing our profits.
