Online Stock Trading

In response to my article regarding my intention to never take a loss, a very helpful reader, Zlatko, dished up some very tasty food for thought. He brought up the topic of Prospect Theory, a theory I didn’t, at the time, know anything directly about. I replied that I wanted to do some snooping, and afterwards, respond a little more intelligently. You can read those comments here. This entire post is actually my reply, because after doing some of that snooping, I found some very intriguing things.

Here’s some of what I found:

1) Zlatko said, when summing up Prospect Theory, that “a great loss hurts more than an equally great gain helps.” For the sake of precision I’d like to pin down “hurts more” because a phrase like that can be both subjective or objective, depending on how whoever using it means it. It turns out that that subjectivity or lack of it can actually play a very crucial role in an understanding of Prospect Theory. In other words, subjectivity, in the Town of Prospect Theory, is the law of the land. Let’s replace that phrase with “thinks it hurts more.” Now we know it’s subjective. Why is that important? Because, according to this Wikipedia article on the subject, “[Prospect Theory] is a psychologically realistic” theory “that describes decisions between alternatives that involve risk…where the probabilities are known.”

2) This is fascinating, Zlatko. I think most people, including me, have participated in the thought, but never had a name for it. In other words, the concept pervades, but is often unseen.

3) I found a terrific example of the theory’s implications. Given choices between mathematically equivalent alternatives, those that “felt” worse, based on context, were declared “worse” or “more bad” than the ones which “felt” somehow better even though they were actually equal alternatives. You can read the details of the example here.

4) In other words, Prospect Theory is gut checking. It explains how our psychologies lead us to value things sometimes irrationally based on how they seem at first glance.

5) Here’s a counter-point though. Both of these sources seem to suggest that Prospect Theory’s relevance is inherently tied to at least a third-party knowledge of the probabilities involved in the alternatives. By bringing it up in response to my intention to never take a loss, it would seem to indicate that Prospect Theory’s relevance to that intention is also based on my knowledge of the probabilities of taking losses in the stock market. Because however, the stock market is not knowable in this sense, than my decision making, when trying to not take losses, is based on something not entirely included in Prospect Theory’s domain. In other words, the alternatives are not quite so definable. The probabilities are not known, and even though I might be using assumed probabilities, I’m not quite convinced that I’m making completely gut-checked-based decisions. Granted, I might however, still be making irrational ones—though determining this seems to need something at least partially outside of the realm of Prospect Theory.

In closing, thank you Zlatko. And thank you. When writing about the topics that I do, my ultimate intention is to either a) inspire people to a re-orientation regarding things related to investment that is “deep thinking through and through” or b) to invite people to engage in some intelligent dialogue about those same things. I have no way to adequately gauge the success of the first intention. But, by having readers responding in the way you did, I can at least partly gauge the success of the second. There is no other way. Thank you, Sir.