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TRADING WHEN THE HEAT (OR, COLD) IS ON

 

Once upon a time, I guess, people assumed that a $100 loss made you as miserable as a $100 gain made you happy. They also assumed that if you were an investor you either liked a deal and took it or didn’t and turned your back on it, irrespective of whether you had made losses or profits that day, irrespective of whether you were stressed out or not, or whether you were sleepy or rested and refreshed. &ldquo... over it,” was considered an old folks’ tale. Alas, not so !
 
Behavioural finance has shown that dollar for dollar losses are more painful than profits are pleasurable. Studies have indicated different comparative magnitudes but, usually, it is estimated that in order to compensate for the pain of a $100 loss one would have to gain between $200 and $300.
 
It goes further. People react to potential gains differently from the way they react to potential losses. Suppose you are asked to choose between the following two:
 
A.   &n... I give you $100 now; OR,
 
B.   &n... We flip a coin. If it is heads you win $200, if tails you get nothing.
 
A logical person – keep in mind Mr. Spock, the Vulcan – would be indifferent between A and B. If you chose A you are more risk averse than if you chose B. 
 
In various tests, it was found that most people go for B. When there are gains to be had, they prefer to make sure they get them and are risk averse.
 
Let us turn to consider potential losses. Choose between:
 
A.   &n... You give me $100 now; OR,
 
B.   &n... We flip a coin. If it is heads you give me nothing but if it is tails you give me $200.
 
Many people now become risk seeking and would prefer B to A. When there
are losses in the air, most people prefer to take a chance.  &nb...
 
This different attitude towards risk is called the reflection effect
 
Now, add stress. Stress actually exaggerates the attitudes we take towards
potential profits and losses. Under stress, we are even more risk averse where profits are concerned and even more risk seeking when facing potential losses.
 
This was shown recently by Anthony Porcelli and Mauricio Delgado of Rutgers University who showed that volunteers under stress were more conservative than usual where profits were concerned but were more risk seeking than usual when trying to avoid losses.
 
How did Porcelli and Delgado put volunteers under stress? I guess it is some sort of interrogation technique: they asked them to immerse their hand in ice-cold water.  (No, the no-stress volunteers did not get to keep their hand dry, they had to put it in room-temperature water.)
 
There is no well-developed theory yet but the experimenters suspect that the results can be explained if we assume that, under stress, we fall back on lower-level thought processes, that is, less rational, more automatic and primitive. We know how “irrational” animals savagely bite at food and try to flee any sort of danger. Stress does not turn us into animals, but makes our behavior more primitive – we know how it is on a nasty day on the trading floor.
 
This paper reminded me of another by Coval and Shumway who found that traders with morning losses were about 16% more likely to assume above-average risk in the afternoon than traders with morning gains. One tries not to close the day with a loss so there’s a tendency to be more risk seeking and to dump rationality if one is in the red after lunch.
 
Finally, keep in mind that lack of sleep is a form of stress. Research on sleep deprivation by Vinod Venkatraman and colleagues at Duke University found that under conditions of sleep deprivation the brain’s nucleus accumbens, involved in the anticipation of reward, becomes more active when “high risk/high payoff” choices were made while the pain of loss was dampened. It seems that sleep deprivation works in an opposite fashion to normal stress by making us foolishly more optimistic. 
 
By the way, it was recently also discovered that most of our problem solving takes place in our subconscious especially while we are asleep. Another reason why “sleep over it” made so much sense ! 
 
 
Anthony J. Porcelli and Mauricio R. Delgado, “Acute Stress Modulates Risk Taking in Financial Decision Making,” Psychological Science, January 2009.
 
Joshua D. Coval and Tyler Shumway, “Do Behavioural Biases Affect Prices?”, The Journal of Finance, February 2005.
Venkatraman, V., Chuah, Y.M.L., Huettel, S.A. and Chee, M.W.L. “Sleep Deprivation Elevates Expectation of Gains and Attenuates Response to Losses Following Risky Decisions”, Sleep (2007).
 
 
 DISCLOSURE:  None required.