Trading in financial securities has sometimes been regarded as a “black box”.
This is particularly the case in markets where there is increased
uncertainty. The current world economy is a prime candidate for increased
uncertainty. Ever since the global financial crisis the market has had the
jitters.
But markets don’t get jitters; it’s the individuals in them. This is not
helped by negative media reports of losses in confidence, and once the ball
begins to roll we get waves of panic selling and markets fall until rationalinvestors begin to consider the lower prices represent good value and buying
pressures correct the falls.
When the uncertainty is high then markets can see large swings in prices asbuyers and sellers move in and out.
As a result of the increased uncertainty we are likely to see stories of
some individuals such as London trader Alessio Rastani dreaming of making lotsof money, some losing lots of money and rogue traders like Kweku Adoboli trying
to recover losses but failing and being exposed.
Generally, the increased risks mean that the number of individuals in the tails
of the distribution increase and some of these are going to be involved in
large amounts of money.
As bad news sells newspapers, we are likely to see increased reports of
losses. Although a million dollars - or a trillion dollars - is a lot of money
to most people, in the whole scheme of things these amounts are relatively
small.
Providing there isn’t a complete loss of market confidence there will be a
future point where prices stabilise.
No one knows when this will occur because no one can predict the future. So
what do you do in such a volatile market? It depends upon your preference for
risk.
In traditional finance, risk aversion is measured by the curvature of the
utility function for wealth. A different view as proposed in prospect theory is
that people are not consistently risk averse.
Although they are more sensitive to losses than to gains, they are also
risk-seeking in their attraction to long shots and in their willingness to
gamble when faced with near-certain loss.
In addition we know that investors do not take a global view of their
assets. They hold separate mental accounts and are more likely to gamble from
some accounts over others.
Princeton Professor Daniel Kahneman (one of the forefathers of prospect
theory) takes this even further by suggesting that these theories are
exclusively concerned with the moment of the decision, not with the moment of
truth when consequences are experienced.
They tacitly assume that individuals correctly anticipate their reaction to
possible outcomes and incorporate valid emotional predictions into their
investment decisions.
But people are poor forecasters of their future emotions and future tastes.
When there is increased uncertainty in the market it may make some traders take
more explicit consideration of the regret they will face when the market goes
against them.
Regret that is anticipated is more likely to be avoided. However, some
traders will have no regrets and enjoy the adrenalin rush that the increased
uncertainty brings.
Unfortunately, since we are poor forecasters of our future emotions,
traders do not have a good idea of how they are going to react when they face
losses.
Some of those that will suffer losses in the current market are going to
face a lot of regrets.
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