The 2002 Nobel Memorial Prize in Economic Sciences was awarded to two psychologists, Daniel Kahneman and Vernon Smith. This result surprised many people because these two awardees were not scholars who had made outstanding achievements in the field of quantitative economics, but rather two psychologists.

The media rushed to report on it, and the "Prospect Theory" proposed by Daniel Kahneman also became a focus of people's attention. This theory once caused a sensation in the academic community, and at the same time, it also aroused the market's attention to investment psychology. The theory explains a lot of irrational behaviors of traders that even precise formulas and economic models cannot explain.

Should you take the profit and leave or bet again?

Suppose you have just made a profit of 3,000 yuan. Now you have two choices: one is to have a 50% chance of gaining 900 yuan and a 50% chance of losing 900 yuan; the other is to have no gain or loss, and maintain the status quo. Or, if you have just lost 3,000 yuan, you also have the same two choices as when you made a profit of 3,000 yuan. Which one would you choose?

This is actually a very classic experiment. Scholars Thaler and Johnson once asked the same question to MBA students. Although there is no right or wrong, good or bad in the choice, the experimental results have an astonishing trend.

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In the above choices, 70% of the students chose to maintain the status quo after making a profit of 3,000 yuan, and when they had already lost 3,000 yuan, 60% of the people were more inclined to continue investing. It can be seen that when they have made a profit, most people tend to be cautious and risk-averse, and prefer to take the profit and leave. When they are at a loss, people will be more aggressive and willing to take a chance again.

Kahneman was fascinated by this, and later he elaborated on these two irrational behaviors in the "Prospect Theory":

1. Certainty Effect: When in a state of profit, most people like to avoid risks;

2. Reflection Effect: When in a state of loss, most people are willing to take risks;At the same time, this theory also proposes that: compared to gains, most people are more sensitive to losses. Specifically in the foreign exchange market, the pain we feel when we lose is far greater than the joy when we make a profit. In addition, most investors harbor a fluke mentality and are willing to participate in low-probability events, which is also the reason why many people frequently buy lottery tickets.

Although traders all believe that they can make the most rational decisions, humans are emotional, and most of the time they cannot do as they wish. Neuroscientists point out that the prefrontal cortex responsible for rational decision-making in the brain and the limbic system that controls emotional responses often make contradictory reactions. Therefore, when we are emotionally excited and need to make rational decisions, the brain does not develop in the direction we hope. Under impulse, it is easier to make irrational decisions.

The two major pitfalls that hinder traders from making a profit are pointed out by "Prospect Theory":

First, leaving the market too early when making a profit. For example, not long ago, the gold price soared, but many people chose to take profits at a high position. At that time, many investment banks raised their expectations for gold prices, and there were several favorable factors in the fundamentals, but they still could not stop the traders' determination to sell.

Those who leave the market early do not want to lose after making a profit, so they put the profits into their pockets early. Although the later gold price trend is volatile, leaving early is not entirely inappropriate. However, if you encounter a market trend that continues to rise, some traders may regret it.

Second, unwilling to cut losses when losing. Another typical phenomenon of the theory is that traders are unwilling to close their positions after losing money, preferring to be stuck rather than closing their positions. Most of these people are out of fluke psychology, and they hope that the future will turn losses into profits. In a trend market, being unwilling to cut losses after losing may lead to greater losses and severely affect traders' emotions.

For example, in February and March of this year, affected by the epidemic, oil prices continued to fall. By mid-March, oil prices had been halved from the beginning of the year. However, as oil prices plummeted, many people in the market also increased their positions, and in the end, they watched the floating losses continue to grow, and finally, they had no choice but to cut their positions out in a painful way.

Every trader hopes to "cut losses and let profits run," but this is contrary to the irrational side of human nature. The result is that traders may have more profitable transactions, but the amount of profit is low; or there are fewer losing transactions, but the amount of loss is high. Therefore, there are very few people in the market who can make a stable profit.Control the Risk-Reward Ratio Before Trading

The "Prospect Theory" merely points out the irrational behavior of investors but does not provide specific solutions. At the same time, Kahneman's theory reflects the different perceptions people have towards risk and return, and what we commonly refer to as the "risk-reward ratio" is an indicator for measuring risk and return. To avoid falling into such traps, we might as well require ourselves to adhere to a rule: seek trades where potential profits outweigh possible losses.

The risk-reward ratio can be used to set entry, exit, and stop-loss points. If the points you might lose and might profit are the same, then the ratio is 1:1. If you want to profit 100 points and lose at most 50 points, that would be 2:1, and so on. Using the risk-reward ratio to limit losses can ensure that the amount of profit exceeds the losses.

The minimum risk-reward ratio is 1:1, which at least allows for a break-even situation. A lot of data shows that at a 1:1 ratio, 53% of traders can achieve a good profit figure within about a year, while only 17% of traders without a set risk-reward ratio can maintain a positive account balance after 12 months.

You can also set ratios of 2:1, 3:1, or even 4:1 to achieve better trading returns. It is also important to note that the risk-reward ratio is not fixed, and traders must adjust according to the time frame, trading environment, and entry and exit points. For example, the return and risk ratio for long-term investors may be as high as 10:1, but for ultra-short-term traders, the return and risk ratio may only be 0.7:1.