Prospect Theory and the gold market

I have been reading Michael Lewis's recent book "The Undoing Project: A Friendship That Changed Our Minds". This is the story of two Israeli psychologists, Amos Tversky and Danny Kahnaman, whose work on Prospect Theory revolutionised behavioural Economics in the late 1970's. (How had I not heard of them before?)

After reading the book and some of the original papers, I started to think about what it meant for trading in general, and the behaviour of investors in the gold market, in particular.

(At this point I could send you off to read Tversky and Kahnaman's papers and the commentaries and critiques that have followed, but as I having criticised others on the forum using YouTube videos to make a case for buying gold, I will try to explain the theory myself. If I fail, there are some good YouTube videos on this subject.)


Prior to Tversky and Kahnaman, most micro economic modelling rested on the assumption that individual economic actors made decisions based on rational self interest. (Some of us who studied Economics 101 back in 1977 were taught the structural assumptions for the Supply-Demand micro models. We rolled our eyes at the dubious assumption of perfect knowledge and rational self interested choices, not knowing that Tversky and Kahnaman were taking a knife that thinking at much the same time.)

The orthodox model was "Utility Theory", which assume a uniform utility value at each price:


It was Tversky who came up with the idea of flipping the Utility curve, and giving consideration the Utility of losses.

They constructed a survey inviting participants to chose between A: a certain profit of $500 and B: a 50% chance of $1,000 profit or no profit. Then they reframed the question to a choice between C: a certain loss of $500 and D: a 50% chance of a $1,000 loss or no loss. Plainly A and C are the same, as are B and D. Rational participants would choose those combinations, but to Tversky and Kahnaman's amazement, 78% of participants chose A and D.

This was "mind blowing". It meant that people's attitudes to risk with respect to profits and losses are asymmetrical. When faced with the prospect of a profit, people become risk averse, and pocketed the certain money. When faced with the prospect of a loss, they become risk seekers, willing to take a chance in order to recover their money. Respondents placed a greater Utility value on losses than on profits of the same amount.



What does this mean in the "real" world?

This irrational preference leads to traders cutting profits and running losses, and confirms why a majority of people lose money in the market when they trade. Even professional desk traders in commercial banks are subject to this bias and banks are required to impose "Stop Loss" restrictions on their desk traders to stop them from "blowing up the bank".


We frequently read the claim on the Gold Forum that the gold market is rigged. It is said that banks make all the money and the small traders get their pockets picked in the market by often unspecified nefarious means. I would like to propose an alternative narrative.

According to Tversky and Kahnaman, it is likely that as many as 78% of the participants in the gold market are subject to natural irrational impulses to take on more risk when their positions are under water. I think that this happened to many investors in the gold market after 2011. At the same time, the banks who may also had been long gold were forced by their internal Market Risk policy to cut their positions. It is obvious that the banks have benefited from the externally imposed risk discipline. To gold investors unfamiliar with internal bank practises, their actions would seem inexplicable and even suspicious. But the forced cutting of positions was very affective in freeing their traders of the cognitive impediments that would have otherwise caused them to lose more money. (If this were the only advantage that banks enjoyed, it should not be surprising that they make so much money in markets.)


None of us likes to think that we behave irrationally. It is natural for people losing money in a market to construct a narrative that places the blame elsewhere, particularly when they don't understand why they are losing money. Sadly, I think that many have fallen into a trap that is old as markets. Hopefully self awareness will help them finding a way out.


As we enter the Christmas-New Year season, I wish everyone all the best. May 2018 see you all cutting your losses prudently, running your profits ruthlessly, and becoming very wealthy and successful indeed.

Kind regards,
Timber1956


Disclosure: When I first took the Tversky-Kahnaman test described above, I chose A and C. I think that makes me rational, but boring...