Trading Behavioural Finance

Psychology and Money

Management

DAVID CARLI
This publication is designed to provide accurate and authoritative information
regarding the subject matter covered. It is sold with the understanding that the
publisher is not engaged in rendering legal, accounting, or another professional
service. If legal advice or other expert assistance is required, the services of a
competent professional should be sought.

Copyright © Seventh edition in May 2021 by David Carli.

All rights reserved. This book or any portion thereof may not be reproduced or
used in any manner whatsoever without the express written permission of the
publisher except for the use of brief quotations in a book review.

First Printing: 2017

ISBN: 9798745887253

Website: www.tradingwithdavid.com
E-mail: info@tradingwithdavid.com
 EDITED

Caroline Winter
carolinewinter4@hotmail.com
 CONTENTS

Introduction – About the Author 1

Introduction – Preface 3

PART ONE: BEHAVIOURAL FINANCE

Chapter 1 – Introduction 6

Chapter 2 – Behavioural Finance 10

Chapter 3 – Investing Irrationalities 20

Chapter 4 – Decision-Making Process 26

Chapter 5 – Prospect Theory 33

Chapter 6 – Equity Premium Puzzle 37

Chapter 7 – Over-Confidence 40

Chapter 8 – Herd-Behaviour 46

Chapter 9 – Personal Development 50

Chapter 10 – Markets Take the... 54

Chapter 11 – Rules You Should Follow 58

PART TWO: MONEY MANAGEMENT

Chapter 12 – Money Management 69

Chapter 13 – Asset Allocation 76

Chapter 14 – Your Investment Success 79

Chapter 15 – First Steps 83

Chapter 16 – Trading Plan 88

Chapter 17 – A Little Bit of Practice 96

PART THREE: NEURO-LINGUISTIC PROGRAMMING

Chapter 18 – What is NLP? 106

Chapter 19 – Well-Formed Outcomes 110

Chapter 20 – Relieve Anxiety and Fear 115

Chapter 21 – Ways to Relieve Stress 122

Chapter 22 – How to Create a New Habit 127

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 PART FOUR: PERSONALITY

Chapter 23 – What is Personality? 134

Chapter 24 – Trading and Personality 138

Chapter 25 – Myers-Briggs Type Indicator ® 141

Chapter 26 – Personalities and Finance 175

Chapter 27 – A.C.T.I.O.N. 198

Chapter 28 – Final Comments 202

PART FIVE: APPENDIX

Appendix A – From my Trading Life 207

Appendix B – Aphorisms and Quotes in Trading 213

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viii
 ABOUT THE AUTHOR
INTRODUCTION

David Carli is an Italian trader and independent financial analyst. He

completed his studies at the University of Pisa, and has since released several
successful books about trading. It is his success and knowledge that David wishes
to pass on to other potential traders, helping them to avoid mistakes and succeed
in the finance and investment markets.

After completing his studies at the University of Pisa, David attended

several exclusive trading courses run and organised by Steve Nison in the United
States of America. David believes that the best person to manage your investments
is yourself. Only you understand how long and hard you had to work to achieve
your savings. By helping you avoid the strategies that do not work, David hopes to
give all traders a better chance at success.

Since January 2007, David has been living and working as a full-time
trader. It was during 2007 that David began collaborating with several highly-
placed trading websites and magazines. During the financial crisis of 2008, David
learned the importance of diversification in trading, helping him achieve low-risk

1
investments. David studied the best approaches across all markets to achieve a
balanced asset allocation of savings.

In 2012 and 2013 David worked for a small Italian Fund, but in
January 2014 he left to manage his investments on a full-time basis. In 2018,
David started to collaborate with an important European commodity investment
company.

He is currently also working on several books for those that wish to

learn more about certain aspects of trading such as Forex, options, commodity and
spread trading, stocks and more. David also teaches interested investors his
personal trading strategies and how to apply them in different markets.

He hopes that through books, courses, videos and articles, people will
understand the financial markets and investment sectors better. On
https://tradingwithdavid.com, you will also find David’s analyses and his trades
made using his strategies. You will see that each aspect of his trades is always well
planned and thought out.

2
 PREFACE
INTRODUCTION

You are a human being, and you know that emotions and feelings
affect your life. Even more so when you are called to make decisions, often with
very little time. Before analysing a market or using a strategy, you have to figure
yourself out.

You have to be able to eliminate, or at least minimise emotions, which

are the primary causes of bad decision making. And to do this, you must first of all
change your mindset. You have to look at trading with different eyes. Unlike what
many people think, trading is not gambling, it is a job and an entrepreneurial
activity. So, traders must have an entrepreneurial mindset and plan every single
detail of this business.

The first section is devoted to an in-depth study into Behavioural

Finance, which has only recently claimed its own autonomy and importance. I can
guarantee that knowledge of this subject makes all the difference when it comes
to trading.

Money Management is another important aspect of trading, even

more important than a good strategy. Equally, you could have a fantastic strategy,

3
but manage it badly, which would lead you into trouble. Money Management is a
fundamental pillar, essential for anyone looking to become a successful trader.

And this is what the second section focuses on.

The third part, instead, deals with Neuro-Linguistic Programming;

you will learn to ask yourself some questions that will lead you to know yourself
better. You will see how to relieve anxiety, fear and stress, and how to change a
habit. You will learn how to improve your trading life.

Personality is the subject of the fourth section. We are not all the
same; it is essential to know what our dominant traits are. You can believe it or not,
but your personality plays an important role in how you trade. You have to mould
your trading style around your particular strengths whilst working to offset your
weaknesses and flaws.

Most traders, or rather losers, prefer to ignore these matters; they

prefer focusing on strategies and charts. Brokers sincerely thank them. Anyone
who reads “Trading Behavioural Finance” will receive great benefits for their
everyday lives. This is because this book will change the way you look at trading,
and most of all, will shift your mindset.

For any question, do not hesitate to contact me at the e-mail address

info@tradingwithdavid.com, it will be my pleasure to answer all of you. Also, visit
my website https://tradingwithdavid.com, where you will find free articles,
analyses, books and trading courses.

4
PART ONE: BEHAVIOURAL FINANCE

5
 INTRODUCTION
CHAPTER 1

I am going to discuss lightly but at the same time completely and

exhaustively (yet without making it too boring), a topic that, in my opinion, is
underestimated by most investors and kept in low regard by many people,
especially those approaching the financial markets for the first time. I am talking
about behavioural finance and money management.

If in a moment of absurdity, I decided to publicise this book by

advertising that I claimed to reveal the most successful technique in the world and
the best set of indicators, it is likely that a lot of traders, or those merely curious,
would buy the book expecting to find a magic formula to becoming rich. These
individuals are people who want to be “spoon-fed” work that has been done for
them, without wanting to start from the origins in order to understand the
underlying dynamics of financial markets.

In this book I am going to talk about things I have tried personally,

some consistently, others more superficially. This is why I have deepened my
study of behavioural finance because I believe it helps us understand our mistakes.

The objective of this book is to highlight some situations that most of

6
you will be able to identify, by employing some practical examples. I assure you
that, by starting from these aspects, you will be able to track an improvement and
develop more quickly an understanding of your own mistakes. This will grant you
an opportunity to grow and improve faster.

It is no coincidence that, in spite of the many, and in some cases

excellent trading techniques available, only a few traders get positive and, above
all, constant results over time.

I think the problems behind failure in the trading world are twofold:
on the one hand, an incorrect behavioural approach to the financial markets; on
the other hand, a lack of any operating rules or money management.

Most people are wrong the approach to the financial markets because
they do not consider trading as a real business. These aspirant traders lack a
trading plan and sound risk management.

Many traders know certain strategies very well that, in theory, should
be profitable, but their lack of a trading plan leads them to improvise exists from
the market by anticipating the target. They could have managed the position
better, and thus achieved a more profitable return.

Or, in other instances, they might be disoriented and incapable of any

reaction when the market goes against their position, causing them to fail to cut
their losses, which they would have done had they had an anticipated exit plan.
They start to “argue with the market,” which only serves to make their losses
heavier until they shut down the computer, hoping that the market will forgive
them their naivety, soon or later.

7
 Since there is no end to the worst, there are also traders who operate
without any risk control. This means that often, the consequences of their
mistakes have a disastrous effect on their trading accounts, which leads them to
realise (but only after) that trading is not their thing, that trading is a business for
professionals.

I think the main problem lies in the fact that trading is considered by
most people to be a type of gambling. Catherine Crook de Camp, an American
science fiction and fantasy author and editor, once said: “if instead of playing the
horses, an individual chooses to play the market, that is his own affair. Only he must
understand that speculating in stocks is gambling, not investing.” This is a perfect
example of how wrong the misconceptions people have about trading really are.

For sure, some “deceptive” have really helped develop this idea in the
collective imagination of our society. Let me be clear from the beginning: trading
is an entrepreneurial business. When you start a company, it is of fundamental
importance to draw up a business plan to avoid any nasty surprises. Your business
plan is called a trading plan.

It is therefore essential to define, before opening a trade, all the

aspects that relate to it. The share of equity you want to risk in each operation, the
maximum percentage of loss you are willing to put up with, stop-loss, target and
risk/reward ratio.

All this will put you in the right conditions to undergo less of the
psychological effects I will go on to discuss in the next chapters, and which
negatively affect your choices. This is because, if you already know what your
maximum loss for your trade can be, and if it is not a problem for your trading
8
account, then you will make that trade serenely, without the stress that
accompanies most traders.

So, you will see in this book that a good trading plan with simple, clear
and precise rules will put you in the best mental conditions to trade and get
success.

9
THE BEHAVIOURAL FINANCE
CHAPTER 2

Each of you knows that in the financial markets, there is never a

guarantee that an event will occur, for instance, that Apple or Corn will reach a
certain price. But with analysis, you can turn the odds of success for an investment
onto your side.

Why is there no certainty in the financial markets? Investors move

the markets, and investors are human beings that do not always make purely
rational decisions. They are often the result of emotions and feelings, and this is
why there is no mathematical certainty. So, markets always have an unpredictable
component.

Bernard Baruch, an American financier, stock investor,

philanthropist, statesman and political consultant, once said: “what actually
registers in the stock market’s fluctuations are not the events themselves, but the
human reactions to these events. In short, how millions of individual men and women
feel these happenings may affect their future.”

And again: “above all else, in other words, the stock market is people. It is
people trying to read the future. And it is this intensely human quality that makes the
10
stock market so dramatic an arena, in which men and women pit their conflicting
judgments, their hopes and fears, strengths and weaknesses, greeds and ideals.”

Behavioural Finance is an approach to finance developed to finance

developed in the 70s that uses psychological and sociological studies into
individual behaviour and the reasoning underlying human action in order to
better understand the anomalies that occur in the financial market. This theory is
based on the study of investors' behaviour in situations of uncertainty which
induce the subject into make incorrect and not always rational choices.

Behavioural Finance offers a more realistic and humane

interpretation of the operation of financial markets. The behaviour approach was
first applied to financial markets to try and explain anomalies (Schiller 2003) and
then later used to consider the set of emotions and feelings that influence market
operators when making investment choices, and consequently, what affects
market trends.

The traditional theory hypothesises the existence of perfectly rational

and omniscient individuals who, in making decisions in conditions of uncertainty,
maximise their expected utility.

Obviously, this is not reality: empirical evidence shows that

individuals make cognitive and emotional mistakes that invalidate the rational
behaviour proposed by classical theory. However, the traditional theoretical
approach cannot be considered wrong, as it has a normative or prescriptive nature:
it theorises ideal situations in the presence (theoretical, in fact) of perfect and
efficient markets.

11
 The behavioural approach, having a descriptive nature, is able to
consider the limits of the rationality of individuals and then evaluates its impact
on decision making. The biggest challenge for behaviour finance is trying to
demonstrate that these mistakes can be considered common to most individuals.

In technical jargon, these mistakes are called “biases.” They actually

represent a predisposition to making a mistake. It is, therefore, a matter of
“prejudices” in the proper sense of the term, that is, something that comes before
judgment, which can lead to an error.

I will begin immediately with a very significant aspect that

characterises each of us, because it is true that we are all different and unique.
Nonetheless, some elements are inside each of us, and delineate us in full. I am
talking about aversion to the losses. It has been proven through empirical studies
that most people are more motivated by a desire to avoid a loss, than any
motivation to make a profit.

This general psychological principle is linked to a survival instinct. If

you think about it, it is easier to give up to on a discount than it is to accept a price
increase. For example, if you go to Walmart and see a T-shirt you like with a 30%
discount, it is not that hard to give that discount up and simply not buy it.

But when the price of that same T-shirt is suddenly increased

significantly, it is more difficult to get over it; precisely because of this mentality
we all have that losses are more difficult to accept. In this case, paying more for a
T-shirt that only a few days earlier was being sold at a lower price.

I do not know about you, but it often happened to me in my first few

12
years as a trader, that I found it difficult to accept whenever a trade went
immediately into a loss. I always lived with the hope that I would be able to recover
that loss sooner or later. To be clear, sometimes this did happen, but far more often
the loss simply continued to increase....and the stop-loss....I was not smart enough
then to hold it at the start level, so I kept moving it higher and higher until the loss
became almost unbearable.

On the other hand, when I was getting a gain, I was more inclined to
take that money home too fast, out of fear that I would not make a profit. So, I
would close the trade without thinking that the profit could very well have
increased, maybe even by a lot. What was I doing? The opposite of what the theory
tells us to do: I was running losses and cutting profits.

Below, you can see the aversion to losses in a graph (figure 1).

Figure 1 - Graph on the aversion to losses

I did not draw the graph above, but it is based on empirical studies

13
taken from samples of people, and which demonstrates how our minds are driven,
when in the Losses area, to increase risk propensity, whilst risk aversion, the Gains
area, is narrower. Nevertheless, as I said, people are different; some are
particularly prone to this problem, whilst others are gradually able to reduce it.

This problem has a name and it is called the “Disposition Effect.” I do

not know if you have heard of it, but it consists precisely of an aversion to losses.
Many investors tend to sell “winners” too soon, i.e., equities with a positive
performance, whilst keeping the “losers,” that is, equities with a negative
performance, for far too long.

Why do you think this happens? Ask yourself this question before
reading on.

Let me give you an example to explain this concept better. Two weeks
ago, you bought Apple shares. Today, after two weeks, the share price has dipped.
Now, due to the so-called regret theory, you are led to delay your realisation of a
loss because it would prove that your choice of trade was wrong. You made an
incorrect decision and it is hard to swallow. Besides this, your regret increases as
soon as a result has to be communicated to others, therefore you do not want to
accept it.

A different situation: after two weeks, Apple shares prices have

increased. In this case, you want to make a profit right now because it represents
proof of your success, evidence that you were right. So, just like before, when you
have to communicate the results to other people (family members, friends, other
traders you are in contact with), this time, the so-called pride theory kicks in. So,
there is a tendency to close the trade as soon as possible to show others your
14
success.

With this simple example, I have explained why traders tend to hold
losing trades for too long, whilst selling winning ones too soon. This is called the
dispositional effect.

I understand that traders often place little weight on these aspects,

thinking much more about strategies, analyses and so on. But I assure you that the
more you manage to control yourself, to control all of these psychological issues,
the more success you will get in the financial markets. And it is much more
important to overcome all these psychological aspects than to have a better
trading strategy.

The volume of research in the field of Behavioural Finance has grown

over recent years. The field merges the concepts of finance, economics and
psychology to understand human behaviour in the financial markets in order to
help form winning investment strategies.

The Concept of Behavioural Finance

Behavioural finance is the study of the influence of psychology on the

behaviour of financial practitioners and its subsequent effect on markets. The
principal objective of an investment is to make money. We usually assume that
investors always act in a manner that maximises their return rationally.

The Efficient Market Hypothesis (EMH), the central proposition of

finance for the last thirty-five years, rests on the assumption of rationality. But it

15
has been proved that people are ruled as much by emotion as they are by cold logic
and selfishness.

While emotions such as fear and greed often play an important role in
poor decision making there are other causes like cognitive biases, heuristics
(shortcuts) that take investors to incorrectly analyse new information about a
stock or currency, and which causes them to overreact or underreact.

Behavioural finance is the study of how these mental errors and

emotions can cause stocks or currencies to be overvalued or undervalued, and to
create investment strategies that give a winning edge over other investors.

I would like to bring out the behaviour pattern of a rational investor.

This rational investor is assumed to act rationally in the following ways:

• Makes decisions to maximise the expected utility.

• Fully informed with unbiased information.
• Absence of any distortion of judgement based on emotions.

It should be kept in mind that risks do not only reside in price

movements of the dollar, gold, oil, commodities, companies and bonds. They also
lurk inside us, in the way we misinterpret information, fool ourselves into
thinking we know more than we do, and overreact to market swings.

Information is useless if we misinterpret it or let emotions sway our

judgement. Human beings are irrational about investing. Correct behaviour
patterns are absolutely essential to successful investing, so to be financially
successful, one has to overcome these tendencies. If we can recognise these
destructive urges, we can avoid them.

16
 Behavioural finance combines the disciplines of economics and
psychology, specifically to study this phenomenon.

The Concept of Bubbles in Stock Market

A speculative bubble occurs when actions by market participants’

result in prices deviating from their fundamental valuation over a prolonged
period of time.

Speculative bubbles are difficult to explain with rational trading

behaviour, and theories have been put forward to explain market psychology
through behavioural finance.

They propose that when a significant proportion of trading activity in

the market is characterised by positive feedback behaviour, it may result in asset
prices shifting away from their fundamental valuation. This price deviation
encourages rational investors to trade in the same direction.

Speculative trades are based upon private information held by

investors today, which is designed to provide investors with higher returns in the
next period when that private information is fully revealed to the market.

This implies a positive correlation in returns as the market

incorporates this information into prices. Trades due to portfolio rebalancing, or
heading, is not information-based and occurs when a trader increases (or
decreases) his stocks holding by buying (or selling) a portion of his stocks holding.

17
 This is accomplices by increasing (or decreasing) the stock price to
induce the opposite side of the trade.

Focus on Intrinsic Value

What are the implications for corporate managers? It is believed that

such market deviations make it even more important for the executives of a
company to understand the intrinsic value of its shares.

This knowledge allows it to exploit any deviations, if and when they

occur, to time the implementation of strategic decisions more successfully. Here
are some examples of how corporate managers can take advantage of market
deviations.

• Issuing additional share capital when the stock market

attaches too high a value to the company’s shares relative to their intrinsic value.
• Repurchasing shares when the market under-prices them,
relative to their intrinsic value. Paying for acquisitions with shares instead of cash
when the market overprices them, relative to their intrinsic value.

Two things must be kept in mind regarding this aspect of market

deviations. Firstly, these decisions must be grounded in a strong business strategy
driven by the goal of creating shareholder value.

Secondly, managers should be cautious of analyses claiming to

highlight market deviations. Furthermore, deviations should be significant in
both size and duration. Provided that a company’s share price eventually returns

18
to its intrinsic value in the long run, managers would benefit from using a
discounted-cash-flow approach for strategic decisions.

It can thus be summarised that for strategic business decisions, the

evidence strongly suggests that the market reflects intrinsic value.

19
INVESTING IRRATIONALITIES
CHAPTER 3

Turbulence within the market is often not liked to any perceivable

event, but rather by investor psychology. A fair amount of portfolio losses can be
traced back to investor choices and reasons for making them. I would like to point
out some of the ways in which investors unthinkingly inflict problems onto
themselves.

Herding

That is a cardinal sin in when investing, as the tendency to follow the

crowd and depend on others for direction is exactly how problems arise in the
market. Two actions are caused by herd mentality:

• Panic buying
• Panic selling

Holding out for a rare treat

Some investors hold onto their trades in the hopes of a reversal, whilst

20
other investors close trades that have great long-term potential, thereby settling
for limited profits.

One of the biggest ironies in the world of investment is that most

investors are risk-averse when chasing gains but become risk lovers when trying
to avoid a loss.

If you shift your non-risk capital into high-risk investments, you

basically contradict every rule of prudence to which each market ascribes,
meaning you are asking for further problems.

Issues

One of the most important issues in behavioural finance is whether

the assumptions of investor rationality are realistic or not.

This concept can be explained with the help of an example. Let’s

assume that John invests and manages his portfolio in an efficient market. Here,
he has to work within seconds in response to the news. There are a great number
of factors that affect John’s decisions. Further, these factors can affect each other.

How can John make the right judgements when information is

updated so frequently? John probably works on a computer throughout the day,
and on which a utility function program is installed for him to work on. Every
decision John makes is based off of the calculations given by his computer. As soon
as the portfolio is rebalanced, the computers utility function program analyses
new alternatives.

21
 This process goes on and on over the course of the day. Obviously,
John does not show any joy when he wins, and no panic when he loses. Can a
human brain behave like this? We know that a human brain can master only seven
pieces of information at any one time.

So, how could one possibly absorb all the relevant information and
process it correctly? People use simplifying heuristics (shortcuts) in order to
control the complexity of information received.

Psychological research has shown that the human brain often uses
shortcuts to solve complex problems. These heuristics are rules or strategies for
information processing, which help to find a quick, but not necessarily optimal,
solution.

Once information is simplified to a manageable level, people use

judgement heuristics. These shortcuts are needed to resolve decision-making as
quickly a possible. Heuristics are also used to arrive to a judgement quickly;
However, they can also systematically distort judgement in certain situations.

Simplification Bias

The first step in reducing complexity is to simplify the decision being

made. However, This also runs the risk of arriving to a non-rational conclusion,
unless you are very careful.

Mental Accounting

People focus on one account (say the purchase of share ABC) in

22
particular when weighing things like relationships with other commitments or
accounts (say the purchase of share XYZ) are usually ignored. I would like to
explain this with the help of an illustration.

For instance, Company A produces bathing costumes, and Company B

produces raincoats. Both companies are new, extremely efficient and innovative,
so that purchasing shares in these companies would be a profitable proposition.

A financial gain, however, depends to a large extent on the weather in

both cases. Company A will produce huge profits if the weather is fine, while
Company B will make a loss, even though this is kept to a minimum, thanks to its
efficient management.

The situation is reversed in the case of bad weather. With mental

accounting, either investment is risky when seen in isolation. But if we take into
account the mutual effect of the uncertainty factor, i.e. the weather, then a
combination of both shares become lucrative, and at the same time a secure
investment.

Representativeness

That is one of the mental shortcuts that make it hard for investors to
correctly analyse new information. It helps the brain organise and quickly process
large stock of data, but can also cause investors to overreact to old information.

For example, if a company is repeatedly giving losses, investors will

become disillusioned with this past data, and thus may overreact to past
information by ignoring valid signs of recovery. Thus, the stock of the company
23
gets undervalued because of this bias.

Challenges

Under the paradigm of traditional financial economics, decision-

makers are considered to be rational and utility maximising. The assumption of
rational expectations is simply an assumption. An assumption that could turn out
not to be true.

Behavioural finance has the potential of being a valuable supplement

to the traditional financial theories in making investment decisions. The
following fundamentals of behavioural finance give us a glimpse of the pitfalls to
be avoided. These are the challenges which need to be overcome and addressed.

1. Hubris hypothesis: is a tendency towards being overly-

optimistic. It is caused by psychological biases. An investor gets swayed by the
momentum generated by the markets in recent years.

2. Sheep theory: is a phenomenon where all investors run in the

same direction. They follow the herd, not voluntarily, but to avoid being trampled.

3. Loss aversion: claims that investors take more risks when

threatened with a loss. Thus, the mental penalty associated with a given loss is
greater than the mental reward from a gain of the same size.

4. Anchoring: this causes investors to underreact to new

information. This can lead investors to expect a company’s earning to be in line
with historical trends, leading to possible under reaction to trend changes.

24
 5. Framing: this states that the way people behave depends on the
way decisions and problems are framed. Even the same problem, but framed in a
different way can cause people to make different choices.

6. Overconfidence: this is what leads people to think that they

know more than they do. It leads investors to overestimate their predictive skills
and believe they can time the market.

Knowing heuristics helps investors acknowledge where they might

be susceptible, and this then helps neutralise to a certain extent distortions in
perception and assimilation of information. This will, in turn, help the investor
make a rational decision and get a cutting edge over the other not-so-rational
investors.

More research on behavioural finance should take place not only in

asset pricing but also in areas like project appraisal & investment decisions and
other areas of corporate finance so that managers can avoid decision traps.
Psychology and irrational behaviour matter in financial markets. Behavioural
finance is relevant in many ways.

It educates investors about how to avoid biases, designing long and

short-term strategies to exploit biases; and being aware that decision-makers in
financial markets are human beings with biases. We also need to realise that an
implicit assumption about behavioural finance is that its findings at the
individual level are scalable to market level.

25
 DECISION-MAKING PROCESS
CHAPTER 4

In everyday life, we constantly make decisions. In some cases, These

decisions are automatic, whilst in others, making a decision can take longer, and
be both more challenging and more complex as a process.

Decision-making characterises some of the most important events in

life: for example, choosing who to you marry, which house to buy, what career to
undertake and whether or not to quit smoking are all decisions that require you to
take into consideration various different elements that need evaluating and that
are based in the future (reflective).

Instead, whether or not you drink another beer before driving, what
pizza you order on an evening with friends or choosing whether or not to run away
from danger all require quick and effective decision making (impulsive).

In trading, a scalper that opens and closes trades in seconds reflects an

impulsive system; as well as a panic selling phase. Instead, position traders and
investors act according to a reflective system.

Decisions, when taken by individuals, imply a voluntary and

26
intentional behaviour that follows reasoning. Typically, decision-making is put in
place to solve a problem. In psychological terms, however, there is a certain
difference between deciding and solving a problem. In problem-solving our
decision act is always bound to the goal we want to achieve. In decision-making,
the decision act is represented by the reasoning of choosing the most suitable
alternative within a series of options.

So, in formal terms, the decision-making process can be considered as

the result of mental (cognitive and emotional) processes which determine the
selection of a course of action among different alternatives. Each decision-making
produces a final choice.

Making decisions usually requires evaluating at least two options that

differ in features and elements. The selection of one option at the expense of
another requires that the person put in place an overall assessment of the different
alternatives, using specific methods of research, processing of information and
decision-making strategies.

In most cases, making decisions means thinking in conditions of

uncertainty: we cannot predict with certainty the future success of the available
potential alternatives, but in the best of cases all we can do is assess the likelihood
of certain outcomes.

Researchers in the fields of psychology and economics generally agree

on the importance of two fundamental human motivations: the desire to reduce
uncertainty and the desire to gain an advantage (Bentham, 1948); these
motivations are fundamental in making decisions.

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 Contrary to the first theories, which saw decision-making which
linked decision making with rational choice, today it is known that human
decisions are based both on emotional and on rational motivations (Cabanac,
1992).

Decision-making is, therefore, strictly connected to probabilistic

reasoning. “Probabilistic reasoning” is an inductive inferential reasoning that
allows us to estimate the probability that a given event within certain conditions
can occur.

Defining the Business Decision-Making Process

In general, the decision-making process helps managers and other

business professionals solve problems by examining alternative choices and
deciding on the best route to take.

Using a step-by-step approach is an efficient way to make thoughtful,

informed decisions that have a positive impact on your organisation’s short and
long-term goals.

The business decision-making process is commonly divided into

seven steps. Managers may utilise many of these steps without realising it, but
gaining a clearer understanding of the best practices can improve the effectiveness
of your decisions.

1. Identify the decision. To make a decision, you must first

identify the problem you need to solve or the question you need to answer. Clearly

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define your decision. If you misidentify the problem that needs solving, or if the
problem you have chosen is too broad, you will knock the decision train off the
track before it even leaves the station.

If you need to achieve a specific goal from your decision, make it

measurable and timely, so you know for certain that you met the goal at the end of
the process.

2. Gather relevant information. Once you have identified your

decision, it is time to gather the relevant information for that choice. Do an
internal assessment, seeing where your organisation has succeeded and failed in
areas related to your decision. Also, seek information from external sources,
including studies, market research, and, in some cases, evaluation from paid
consultants.

Beware: you can easily become bogged down by too much

information, facts and statistics that seem applicable to your situation but that
might only complicate the process.

3. Identify the alternatives. With relevant information now at

your fingertips, identify a possible solution to your problem. There is usually more
than one option to consider when trying to meet a goal. For example, if your
company is trying to gain more engagement on social media, your alternatives
could include paid social advertisements, a change in your organic social media
strategy, or a combination of the two.

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 4. Weigh the evidence. Once you have identified multiple
alternatives, weigh the evidence for or against said alternatives. See what
companies have done in the past to succeed in these areas, and take a good hard
look at your own organisation’s wins and losses. Identify potential pitfalls for each
of your alternatives, and weigh those against the possible rewards.

5. Choose among alternatives. Here is the part of the decision-

making process where you have to, you know, make a decision. Hopefully, you
have identified and clarified what decision needs to be made, gathered all the
relevant information, and developed and considered the potential paths to take.
You are perfectly prepared about which to choose from.

6. Take action. Once you have made your decision, act on it!
Develop a plan to make your decision tangible and achievable. Develop a project
plan related to your decision, and then set the team loose on their tasks once the
plan is in place.

7. Review your decision. After a predetermined amount of time,

which you defined in step one of the decision-making process, take an honest look
back at your decision. Did you solve the problem? Did you answer the question?
Did you meet your goals?

If so, take note of what worked for future reference. If not, learn from
your mistakes as you begin the decision-making process again.

Decision-making can determine the difference between success and

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failure. Decision-making cannot be taken lightly; it is a huge responsibility. When
making a decision, it is better to take the necessary time and not rush into it,
research, investigate and examine the issues; always consider the options and
different solutions.

Sometimes decisions will be urgent and will need to be taken in the

moment. Taking urgent decisions does not mean not following a process.
Experience will make decision-makers confident. It is always better to make a
decision than to let a problem get larger.

These are some common mistakes that should be avoided while

making decisions.

Decisions should be made quickly, efficiently and in the best interest

of the company. Being unable to make a choice can only worsen a situation. Avoid
not making a decision when it is needed. Some decisions are easy to make, Whilst
others take time. Just make sure a decision is made.

Do not postpone making a decision

Being under pressure and not analysing a problem are not reasons to
postpone making a decision. Allow for enough time to gather information, analyse
the situation, choose a course of action and formulate a solution. Following the
steps one by one towards making a decision is simple. Do not be afraid to do so.

Reliable information is crucial to making decisions

Not having access to the correct information and the proper sources

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can certainly create problems. Avoid bad decisions by checking the accuracy of
your information and sources. Do not be fooled.

Know the cause of the problem before making a decision

Be sure to differentiate the symptoms from the cause of the problem.

Knowing the cause will always facilitate a better decision.

Always analyse the problem

Identify, isolate and select what information is useful and accurate,

and what is not. Every problem has different variables, observe them and analyse
them, follow a procedure, define the objectives and be sure to figure out the
limitations before making a decision.

All decisions need follow-up

After making a decision it is important to implement it with a follow-

up. Implementing a decision is just the first step in solving a problem. Following
up will guarantee that the execution is properly done and the problem solved.

Following these simple recommendations will help in the decision-

making process. Someone has to make decisions and take the lead.

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 THE PROSPECT THEORY
CHAPTER 5

In 1978, the American psychologist Herbert Simon won the Nobel

Prize in Economics for his research on decision-making in economic
organisations. He demonstrated the inefficiency of the human brain in reasoning
processes and the resulting tendency of making satisfactory, but not optimal
choices.

That same year, Israeli psychologist Daniel Kahneman (2002 winner

of the Nobel Prize in Economics), together with his colleague, Amos Tversky,
questioned how we might change our decision making when we are in risky
situations, outlined in the so-called Prospect Theory.

The Prospect Theory is a descriptive theory whose purpose is to

explain how and why certain choices differ systematically from those provided by
a standard method, or from a based on rational behaviour.

Until then, the theory that was commonly being shared was that of
expected utility, that is, a rational choice model used to describe the economic
behaviour of subjects, who make choices according to the real probability of
making a profit from their decision.
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 The two psychologists, however, noted that this model did not work
in cases where the subject has a risk placed in front of them. Different dilemmas
were proposed to research participants who were made to experience systematic
transgressions according to the principles of utility expected.

For example, if I ask you to choose between the following options:

A. A 90% chance of winning $ 500.00.

B. Guaranteed win of $ 450.00.

What would you choose?

People do not consider the actual potential monetary gain derived

from probabilistic calculus. The psychologists noticed a regular occurrence called
“certainty effect”: participants, when asked to compare the possibility of receiving
a sure profit with the probability of receiving a bigger one, overestimate the gain
when it is certain, choosing option B in the majority of cases.

In addition to checking peoples' preferences in the case of gain, the

researchers also tested the decision making involved in the event of a possible loss.

If I now asked you to choose between the following options:

A. A 90% chance of losing $ 500.00.

B. A definite loss of $ 450.00.

What would you choose in this case?

They noted a different behaviour in the participants, so much so that

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they called the phenomenon “reflection effect”: most people choose option A in the
majority of cases. They prefer running the risk of making a probable significant
loss (one that is not certain), rather than accepting the certainty of a smaller loss.
The same principle, the overestimation of specific data, favours risk aversion
when it comes to earnings, and risk research, when it comes to losses.

This discovery was analysed by the authors who listed the various
repercussions of Prospect Theory by applying them to every activity in daily life.
People do not rationally reflect on the real probability of an event, instead, they
select information based on individual subjective schemes until they determine
different choices. Researchers define this behaviour as “isolation effect.”

For example, people can invest their money in a business, with a

chance of losing their entire capital. On the other hand, there is an opportunity to
earn a fixed wage or a percentage on earnings. The certainty of income increases
the attractiveness of this option whilst not considering the possible alternatives.

There is still much to be said, but I would rather stop here. Otherwise,
I would end up going into too much detail and, in the end, this chapter would result
unclear and tedious. Prospect Theory attaches great importance to the way in
which decision-making is interpreted. It proves that problems are formally, the
same, but when described in terms of gains and losses, give rise to different
decisions.

So, in trading, we can see the “certainty effect” when investors sell
winning trades too soon, and the “reflection effect” when they hold losing trades
for too long.

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 To conclude the discussion of the two questions above, there are no
right or wrong answers, what matters is that there must be symmetry. If you
decide to take a sure earning of € 450, the loss must also be securely at € 450 secure.
If instead, you choose the probability of getting € 500, then you can choose wither
the certain loss of € 450 (in this case you would have an excellent aversion to risk),
or the probability of a loss of € 500.

When we speak of symmetry, we refer to a propensity for balance.

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 Hello, if what you have read has caught your interest, you can buy this
book at the price of $ 9.99 (Kindle and PDF) and $ 19.99 (Paperback). Click on the
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behavioural-finance.

Thank you!

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