Why Your Gut Is Wrong


Most untrained people lose more than 60% of the time when they follow their gut.  Why?  All humans hate losing MORE than they love winning. Researchers in behavioral finance have run many experiments to prove this is true, but you can prove it for yourself with this mental exercise.

Consider this scenario: You look down and on the sidewalk see a $20 bill which you reach down to grab and put in your pocket happily continuing on your way.  A few blocks later you decide to put that $20 bill in your wallet, but when you open your wallet and find it empty; missing $50.  Are you still happy about the $20 you found or disappointed about the empty wallet?

Emotionally, how much money over the $20 you found would it take for you to walk home with at least a mildly positive feeling, as opposed to being downcast about how much money you lost? How much money you would have had to find is likely to be some amount more than the lost $50.  In fact, research has been done to show that the it usually takes about twice as much than was lost…in this case $100.

Now anyone could look at the situation and say something like, “Wow, I found some money! That’s all the matters, I’m happy about THAT!” but the reality is that almost all people do not. They are FAR more likely to join these two experiences in their mind and be so disappointed about losing money that it takes finding even more money to make up for what they lost before they feel better.

This translates into the markets very well.  Your own psychology will attempt to get twice as much gain for whatever loss you allow. So when you don’t plan a trade you naturally go into a mode where you risk 1 to make 2 (or more). This strategy is mathematically calculable because you risk two to make one. This in turn implies that you will only win 33% of the time if you allow your gut to make market decisions.

The value of knowing your natural trading style and probability profile is having a clear plan about what you risk, what you gain, and how frequently you plan to win.  It helps you clearly understand the likely winning and losing streaks you can expect and gives you a clear structure about what strategies you should focus on and eventually master.  Having this sort of fundamental understanding gives you a significant advantage when putting your money to work.