Let your Profits run and cut your Losses short

In one classic experiment conducted by Daniel Kahneman and Amos Tversky, pioneers in the field of blogprospect theory, subjects were given a hypothetical choice between a sure $3,000 gain versus an 80% chance of a $4,000 gain and a 20% chance of not getting anything.

The vast majority of people preferred the sure $3,000 gain, even though the other alternative had a higher expected gain (0.80 × $4,000 = $3,200).

Then they flipped the question around and gave subjects a choice between a certain loss of $3,000 versus an 80% chance of losing $4,000 and a 20% chance of not losing anything. In this case, the vast majority chose to gamble and take the 80% chance of a $4,000 loss, even though the expected loss would be $3,200.

In both cases, people made irrational choices because they selected the alternative with the smaller expected gain or larger expected loss. Why?

Because the experiment reflects a quirk in human behavior in regard to risk and gain: People are risk-averse when it comes to gains, but are risk-takers when it comes to avoiding a loss.

This behavioral quirk relates very much to stock trading, as it explains why people tend to let their losses run and cut their profits short. So the old cliché (but not any less valid advice) to “let your profits run and cut your losses short” is actually the exact opposite of what most people tend to do.

Source : Taken from Daniel Kahneman and Amos Tversky work paper


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