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The Market Guys

Are you out of your mind?¹

How many times have you looked at your trading diary and realized that you're missing a simple key to success: if only you had bought when you sold and sold when you bought, you'd be showing a handsome profit? There are some people who can best be described as reliable contrarian indicators. Watch what they do and then take the opposite position. While we laugh at the irony of this example, the fact is that we often find that we're working against ourselves when we take a close look at our trading style. This article will explore the psychological aspects of managing trading risk and how we can accommodate our own limitations.

Are You Out of Your Mind?
Research has shown that our own minds work against our financial best interest. For that reason, when we develop a plan to manage trading risk, it is imperative that the plan be designed in such a way as to minimize our interference in the execution of the plan. Simply, we need to create a foolproof plan and recognize that it is ourselves that we're protecting against.

To illustrate this, we can look at a popular experimental economics game referred to as the "Ultimatum Game". In the Ultimatum Game, two players are given the opportunity to divide a sum of money and there is no reciprocation. That is, each player only has to make one decision and the game is over. To start, player A is told to divide an amount, say $10, between player A and player B. The split can be any ratio with one exception: player A cannot keep the entire amount. The worst case split for player B is that player A will choose to keep $9 and give $1 to player B. The next step is for player B to decide whether to accept or reject player A's offer. If player B accepts the offer, then both players get the amount of money set forth in the offer. If player B chooses to reject the offer, then both players walk away empty-handed.

Here's the key question: When is it advantageous for player B to reject an offer? The answer, of course, is never! In the worst case scenario, if player B accepts the offer, he will still receive $1 that he otherwise wouldn't have. However, experimental results show that offers of less than 20% ($2 in our example) are often rejected. Subsequent investigation reveals that there is an element of "fairness" that's considered by player B and if the offer is perceived as "unfair" then the offer is rejected. Player B would choose the defense of perceived fairness rather than improve his financial condition if they appear to be mutually exclusive choices.

Before you think that you're the exceptional trader who can overcome this propensity through sheer determination, consider this: A research study scanned the brains of Ultimatum Game players as they responded to fair and unfair proposals. The results were published in a 2003 article in Science magazine entitled "The Neural Basis of Economic Decision-Making in the Ultimatum Game". It was shown that unfair offers elicited activity in brain areas related to emotion which suggests an important role for emotions in decision-making. The conclusion for the trader is that we have to recognize that our emotions are an integral part of our financial decision-making and then take the necessary steps to ensure that we don't harm ourselves in the process. Of all professions, the trader must take care to address this point since financial decisions are made every trading day.

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1 This article ("Article") has been written and provided by The Market Guys, an independent third party that is not affiliated with E*TRADE Canada Securities Corporation ("E*TRADE Canada") or its affiliates. The Article is provided to you for informational purposes only. No information contained in the Article has been endorsed or approved by E*TRADE Canada, and E*TRADE Canada is not responsible for the content thereof or for any third parties (including The Market Guys), or for any third party opinions, products or services. E*TRADE Canada does not provide investment advice or recommendations and you will consult with and rely upon your own advisors. You are fully responsible for your investment decisions and any profits or losses that may result.