The book we're reading today has quite a pedigree; the author is Richard Thaler. He was awarded the Nobel Prize in Economics in 2017 for his research and contributions to behavioral economics. He also serves as the president of the American Economic Association, and Thaler is considered a pioneer in the field of behavioral economic theory.

Behavioral economics is a branch of economics that studies the psychological, cognitive, and emotional aspects of human decision-making in economic behavior, such as irrational economic actions and the reasons behind them.

As traders, our financial transactions are inherently a form of economic behavior. The title of the book we're discussing today is "Misbehaving." By studying the erroneous economic cases presented in the book and understanding the causes behind these behaviors, we can identify issues in our own trading.

This book is quite fascinating, with many viewpoints that challenge common sense, broadening our understanding and helping us to have a more objective view of trading.

1. Humans can only be rational to a limited extent.

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Before we dive into today's content, to facilitate understanding, let me briefly explain the assumption of the rational economic man in traditional economics.

In traditional economics, it is assumed that when individuals engage in various economic activities and make decisions, they are "fully rational economic agents" who always make the best choices.

For instance, when investing, under the assumption of the rational economic man, individuals are always expected to make rational judgments about risks and returns, and their investment actions are always considered rational and correct.

However, anyone who has traded knows that in investment transactions, people simply cannot be completely rational, and in fact, they can be the very opposite of rational, acting "wildly irrational."

The author of this book, Thaler, also recognized the flaws in the economic man assumption. Due to the complexity of human behavior, impulsiveness, intuition, and personal preferences all influence the degree of rationality in decision-making, making it impossible for humans to be fully rational. Moreover, behaviors are judged and decided by the brain's nervous system, but the human brain and nervous system are far from perfect, making complete rationality unattainable.In summary, above rationality, there is always a more rational decision to be made.

Each of our cognitions has its limitations, which, to put it bluntly, means that our capabilities are finite, and we can only achieve a limited degree of rationality.

Once you recognize your own limitations, you will not aim to make an infinite amount of money from the financial markets, but rather, within the scope of your rationality, earn the money you can reasonably earn.

Only after realizing this can you understand where the boundaries of your rationality lie, where the boundaries of profit lie, and beyond those boundaries lies the abyss of irrationality.

This is also why I transitioned from early aimless trading to later adhering to a trading system, because a trading system is a set of rules that constrains oneself, allowing one to earn the money they should within the boundaries of their rationality.

Understanding one's desires and the boundaries of one's rationality is essential for having reasonable expectations of profit and for making rational judgments and actions.

2. Discussing a few common irrational behaviors.

For example, when shopping in a store, if one item is at full price and two items are at a 20% discount, would you buy an extra item you don't need just to get the discount, even if it means letting it sit unused?

Or consider when we go shopping at a supermarket or order dishes at a restaurant while extremely hungry, do we tend to buy more than we actually need?

If a market trend is clearly outside of one's trading plan, but the trend appears to be very perfect, would we be unable to resist making a trade?When it comes to the stop-loss point, some people just can't bear to cut their losses, but instead, they go against the trend by increasing their positions, thinking that as long as the market corrects, they won't lose money. Is this kind of fluke mentality also present?

You clearly don't have much capital, yet you don't hesitate to borrow money, even take out loans to trade, just like going to the supermarket in a state of hunger, where the desire for food far exceeds that of a well-fed state. In this irrational state, you will only consume more crazily, leading to financial loss.

These are common irrational behaviors in life and trading, and I believe many people have experienced them.

In the following content, I will discuss three important theories in Thaler's behavioral economics to clarify what causes these irrational behaviors and how to make changes.

3. Thaler's three famous theories on behavioral economics.

In his research on behavioral economics, Thaler summarized three famous economic theories, namely: the endowment effect, mental accounting, and self-control.

These three theories are the core of behavioral economics and are also the main research results that earned him the Nobel Prize in Economics. These theories influence the decisions we make in our economic behaviors.

I. The endowment effect.

The endowment effect refers to the phenomenon where the value assessment of an item or asset that a person owns is greater than the value they would place on it before they had acquired it.

Regarding the endowment effect, Thaler conducted a very classic experiment with coffee mugs.Twenty-two experimental participants, acting as buyers and sellers, conducted a process of trading four times. The specific process of the experiment is quite complex, so I won't go into detail; instead, I'll discuss the results.

The average price at which participants who owned a mug were willing to sell it was $5.25; whereas buyers in the experiment who did not own a mug were willing to buy it at an average price that was half of the selling price. He later conducted a similar experiment with pens, and the selling and buying prices were also roughly in a 2:1 ratio.

Due to loss aversion, people who owned the mugs considered them as their own, and selling them meant a form of loss. Subsequently, Thaler concluded through a series of studies that the pain of losing is approximately twice the joy of gaining.

The endowment effect is similarly reflected in traders. There is a saying in trading: "He who can buy is an apprentice, but he who can sell is the master." There are always people who struggle with exiting positions because closing a position means losing something they possess, which creates greater psychological pressure. People tend to be more indecisive and anxious about closing orders.

Consider whether you've had such feelings: a significant trend emerges, and you've made $100, but instead of feeling happy, you're lamenting that if you had held on longer, you could have made $500. You feel like you've lost $400, wallowing in the pain of loss, forgetting that your trading outcome was profitable. The next time you trade, you decisively break the rules, increase your position size, and extend your holding time, but this time the market does not trend as expected, resulting in a loss.

Or perhaps, your account was initially profitable, and you were content, but then the market began to correct, and your account gradually moved into a loss, reaching your stop-loss point. Yet, you simply couldn't bring yourself to cut your losses, feeling that it was unbearable to go from profit to loss, and ultimately, you end up losing even more.

It's the aversion to loss and the fixation on what has been lost that leads to repeatedly breaking one's own psychological limits, seemingly providing temporary relief but actually losing more money, thus bringing more pain and creating a vicious cycle.

The endowment effect is very common among traders, or rather, it is common and potentially fatal in human behavior. It's like being in a relationship where you're already suffering and being tormented, but you persist out of fear of losing that person, which is merely self-consumption and meaningless.

Therefore, knowing when to cut your losses and understanding the importance of doing so is crucial.

II. Mental Accounting.Psychological accounting refers to the tendency of individuals to categorize income from different sources into separate mental accounts.

For instance, when we earn our salary through hard work, we are more inclined to deposit it into a savings account. When we receive a year-end bonus, we might be more tempted to impulsively purchase a new phone or a piece of clothing as a reward for ourselves. However, if we come into money through lottery winnings, we are more likely to spend it recklessly because it feels like the money has come too easily.

Despite the fact that it is all our own money and the nature of the money is identical, we allocate it into different mental accounts based on its source. This leads to irrational spending behaviors.

Psychological accounting is also prevalent in trading.

I often say in trading that when a novice enters the industry and starts off by making a profit, especially a substantial one, it might not be a blessing from the heavens but rather a gift from the devil.

It's akin to someone going to a casino and immediately experiencing the thrill of winning big with a small bet, gaining a lot of money quickly. This can completely distort their perception of money. They may start to believe that money comes too easily, unlike in real life where one has to work diligently and carefully, often enduring much hardship to earn it.

From then on, they might squander their money, making increasingly larger bets. In the context of trading, if a trader starts off with significant profits, their expectations for position sizing and trading returns will likely become completely skewed, and they may struggle to break free from this mindset for a long time.

There are also situations where traders, when their accounts show profits, are more inclined to avoid stopping losses, thinking that even if they gamble and lose, they won't lose their principal.For example, holding two orders, one profitable and one losing, according to the rules of the trading system, the profitable order should be held, and the losing order should be stopped in time. However, many times we will close all orders directly when the two orders reach a break-even point, which is also the work of our mental accounting.

Many traders, once they have made a profit, will then enter a losing phase, as if it were the fate of the trader, which is quite magical.

Therefore, I often remind everyone that if there is a profit in the trading account, you can take out a part of it first, which can calm down and not engage in irrational trading behavior due to having too much money in the account.

In addition, everyone should correctly understand the value of money. Whether it is the money made from profits or the money lost, it is their own money, and there is no essential difference between them. We should put them into the same mental account to take them seriously.

III. Self-control theory.

Self-control theory refers to the fact that in economic activities, people will sacrifice immediate interests for future benefits, just as we will pay for pension insurance instead of spending that money now.

However, the difficulty of self-control is beyond our imagination. Thaler proposed the planner and doer model. There is a planner and a doer in a person's inner world, and the two have been fighting each other.

The planner is rational, has made plans, understands the delay of enjoyment, and endures the present in exchange for greater benefits.

The doer is irrational, likes to enjoy in time, does as he pleases, and is even capricious.

This planner and doer model exists in the minds of every trader, and there are two little people in the trader's mind who have been fighting all the time.Trading is an activity that necessitates delayed gratification. For instance, when an order is profitable, the market may have just begun to move, and there is still a long way to go before reaching the profit target. Moreover, according to the trading system, one must hold the position to make a profit.

From the perspective of a rational planner, it is essential to maintain the position, while the irrational actor desires to close the position immediately to experience the thrill of realizing profits.

Alternatively, we are well aware that trading profits are calculated on an annual basis, and only overall profitability counts. Yet, we still can't help but focus on the outcome of each individual trade.

When we encounter these issues, we struggle, knowing what is right and what is wrong, but we are unable to exercise self-control.

The book also provides solutions to these problems.

It mentions a 1975 article about animal delayed gratification, which gave animals two choices: if they wanted immediate satisfaction, they would receive a small reward; if they chose to delay satisfaction, they could get a larger reward, and they were trained accordingly.

After long-term training, the animals all chose to receive more food, making the choice of delayed gratification.

In fact, we can also achieve delayed gratification in trading through training.

For example, as we mentioned earlier, the actor wants to close the position quickly to secure profits, while the planner can hold the position and choose delayed gratification. How can we make ourselves hold the position?

Through extensive review of past trades or practice with simulated accounts. We can simultaneously employ two types of review methods, one using the actor's thinking pattern and the other using the planner's thinking pattern, to obtain two different outcomes.In two different market conditions, immerse yourself extensively in the impact that the market brings to us, and compare the final outcomes. As a result, both the outcome and the trading operations will be deeply etched in your mind and become part of your muscle memory.

You will gain a clearer understanding of the significance of delayed gratification, which in turn enables self-control in trading.

Some may argue, "I know that adhering to delayed gratification in trading is key to making money, but I just can't seem to do it."

Let me put it this way: I once spent two years without engaging in live trading, focusing solely on backtesting and paper trading. Eventually, I reached a state where taking losses hardly fazed me; at most, it was like a small electric shock from a needle. I could execute my trading system like a robot, with no desire for opportunities outside my trading system, and always hold positions neither too early nor too late, strictly adhering to the rules.

Understanding the principles is crucial, and self-training is equally important.

When we undertake tasks, we must not only know what to do but also understand the reasons behind it.

4. Now, let's discuss two interesting points from the book.

The content of the book is quite rich and intriguing. Due to the limited space today, I cannot elaborate on everything. I suggest you read the original work for yourself.

Firstly, due to the aversion to loss, it is advisable to minimize the frequency of checking your investment accounts.

This is also something I often mention: to excel in trading, you need to maintain a certain distance from the market.Many people enjoy frequently monitoring the market. When you stare at those candlestick charts and the balance in your account every day, even the slightest price fluctuations and changes in your account's profit and loss can have a significant psychological impact on you.

Due to our human aversion to losses, seeing the profit amount shrink and experience a slight decline can cause psychological ripples. If you can't change it, can't you avoid it?

So, in the matter of monitoring the market, it's better to be a bit lazier.

II. Prospect Theory.

Prospect Theory refers to the tendency of people to pursue risk when facing losses.

The book gives an example of betting on horse racing. In the last race of the day, most people who are at a loss will bet on the horse with the highest risk and the highest odds in the last race. This means that horse racing bettors who are losing money in order to break even or recover their losses choose high risk.

In actual trading, this phenomenon is very common. Many traders, once their accounts show a loss, will start to gamble on the market, causing their psychological state to collapse. They may even go all-in, increasing their positions as their losses grow, ultimately leading to a margin call.

Although it's painful, that's the reality.

When everyone is crazy, we need to be rational; when everyone is losing money, we need to stay steady; when everyone is greedy, we need to be cautious. This is the secret to making a profit.

Finally, let's end today's article with a quote from the book.We must remember: When faced with significant losses, if people have a chance to recoup, they will generally be willing to take risks, even if they are usually risk-averse. So, be careful!