The Psychology of Risk: Mastering Market Uncertainty

A variety of recent behavioral economic studies have shown that
most people are willing to accept risks in order to avoid losses but
have a built-in tendency to avoid risks when seeking gain. My own
observations after 40 years of psychiatric practice is that it is hard for
most people to summon the nerve to take risks and to live their lives
in the creative realm of possibility where there are no guarantees or
certainties and where you can become only what you are willing to
commit yourself to becoming. Although the willingness to take risks
and manage them is the quintessential activity of trading, traders often
suffer the same lack of courage.

Most traders are willing to accept risk in order to avoid a loss
(e.g., holding on to losing positions) and are more cautious when
dealing with potential gains (e.g., reluctant to add to winning positions).
In other words, a trader would be more willing to take a
greater risk in an effort not to lose $500 than he would to gain $500.

Given this propensity, you might understand why a trader would stay
in a losing position in hopes that the tide will turn. Known as
Weber’s Law, this and many other principles of human behavior
highlight the importance of understanding the psychological underpinnings
of risk taking.

Put another way, many people prefer to make decisions related to
a certain gain (as in holding on to losing positions) over decisions that
might lead to something better but have the element of a gamble (as
in getting bigger or adding to winning positions). Whereas most of us
tend to avoid the adrenaline-producing rush of risk taking, as a trader
you cannot avoid it. The very essence of trading involves risk taking,
and how you manage your risk is what defines the line between success
and failure.

In an effort to contain our fears, we establish certain perspectives
early in life that stabilize the world for us but that eventually constrain
us and distort our view of reality. As a result, most of us don’t create
our lives independently of the life principles developed in the past. As
shown throughout this book, the same holds for traders—many of
whom must learn to function independently of their own constraining
influences in order to survive and to succeed in the face of the
unpredictable and random swings of the marketplace.

Taking risks, from my point of view, means being willing to create
a vision from which to trade to increase your capacity to interact
with reality without being limited by your fears or your past perspectives.
This means looking at reality without the constraints of
prior rationalizations or self-justifications. When you view reality this
way, you begin to tap the hidden potential that enables you to become
more fully engaged in your life.

In the trading arena, being fully engaged means making realistic
assessments of the market and being willing to face the truth about
your positions (your gains as well as your losses) without being caught
in the throes of rationalization and denial that are so readily triggered
by events.

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The Psychology of Risk: Mastering Market Uncertainty