Abandoning Risk Limits

Abandoning Risk Limits

Winning traders manage risk. Risk management is vital for their survival. But financial risk management doesn't come naturally for most people. Behavioral economists have shown that people can be extremely undisciplined when it comes to risk control. After a big win, they can become overconfident to the point of exuberantly taking unnecessary risks. And after a big loss, they have a strong desire to recoup their losses. Gaining awareness of these human decision making biases can help you neutralize them, and prevent them from shattering your trading discipline.

In a classic study, behavioral economists Richard Thaler and Eric Johnson asked participants to take two gambles, one after the other, using real money. In the first of the two gambles, participants either won or lost money. The point of the study was to see what people would do in the second gamble. Would they enthusiastically take another risk or would they shrink away, averse to risk?

When participants won on the first gamble, they were willing to take a chance on a second gamble. But participants who did not win on the first gamble refused to make a second bet. Behavioral economists call this finding the "house money effect." When people obtain a windfall, they don't mind losing it. They don't see the money they won as their own and are willing to risk it freely. It's like gambling with the casino's, or house's, money. They think, "It's not my money. It doesn't matter if I blow it all."

When participants lost money on the first gamble, in contrast, they were not willing to make a bet on the second gamble. It's like when a snake or a spider bites you. Once you've been bitten, you're afraid to get bitten again. You don't take a chance in the future. You're too afraid. People don't want to take a risk when they have a clear image in their mind that they are going to get hurt. Behavioral economists call this phenomenon the "snake bite effect."

When losses are especially great, however, people easily overcome the snake bite effect. There is a strong and pervasive tendency to recoup losses. In the "break even effect," people are willing to go double-or-nothing to make back what they have lost. They will take especially risky gambles on the chance that they can break even quickly. But riskier bets often mean even bigger losses in the long run.

Managing risk is essential for long term survival. But traders are human, and humans can behave irrationally. Overconfident online investors who have made big wins, for example, tend to over-trade and take riskier trades than are prudent. And when novice traders have a long series of losers, many are tempted to make bigger, riskier trades in the hope of recouping what they've lost. Instead of falling prey to these biases, it's vital to steadfastly manage risk no matter what. Don't let common decision making biases compel you to abandon your risk management plan. Winning traders manage risk. If you can control your impulse to react irrationally and emotionally, you can easily manage risk, and achieve enduring financial success.