Prospect Theory (for traders):
1. Gains feel less good than losses hurt
*takeaway: Let winners ride, and take losses more aggressively*
People tend to ride losses too long and take gains too early.
In technical speak, people are risk averse over gains (concave utility) and risk seeking over losses (convex utility).
Over time, the market keeps too much compensation for risk, while human investors take more punishment than they need to.
2. People overweight low-probability events, underweight high-probability events
*takeaway: Use math to assess distributions, don't eyeball it*
Our brain makes the extreme outcome seem more salient, which is an evolutionary bias towards survival.
Our gut feel is predictably biased to pay less importance to the common outcome, and to pay more attention to the extraordinary outcomes. Intuition cannot reliably make impartial weighing decisions.
Mathematics gives us tools to calculate the shape of a distribution. We can take sum-products over a discrete distribution, or we can integrate over a continuous function using calculus. The answer will be more accurate (i.e., unbiased) than the conclusions we draw using human experience.
High school economics already taught that price is determined by supply and demand. Later while on the job, I learned about more esoteric topics like Hayekian monetary theory.
In between, I paid beaucoup $$ for an Ivy League Economics degree. The only piece of academic economics I found specifically useful in my trading career is Prospect Theory, an empirical branch of Behavioral Economics.
