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The Simplest Way to Understand Behavioral Finance

Imagine that you're an NFL player that is renegotiating your salary.

After back and forth with your agent and the front office, you come down to some terms.

It's not what you wanted, but you'll take what you can get:

A 1 year deal for $3 million per year, and for every game you win, you get an extra $200,000.

With around 12 games in the regular season, you stand to get an extra $2.4 million on top of your base salary.

That's not bad. If you're part of a winning team the incentive helps and you are extra motivated headed into the season. If you win, great-- if you lose it sucks but it's not that bad.

Flip It Around

Now consider a different deal:

A 1 year deal for $5.4 million per year, and for every game you lose, you get $200,000 taken away from your paycheck.

With around 12 games in the regular season, you stand to lose at most $2.4 million from your base salary.

This is where human behavior comes in.

The outcome of both deals are the same monetarily. There's no difference in total money in either deal.

But the second deal would change you. Not only would you be motivated to win, you'd be much, much more upset if your team lost.

Perhaps you'd play dirtier, or yell at your teammates more, or try anything to get that extra edge in the outcome.

The Pain and Pleasure Paradox

See how that would work? Even if the outcomes are the same, the pain of losing money is completely different than the pleasure of making money.

This is known as Prospect Theory. 

It's also why markets will selloff different than how they rally. It's why you are so stubborn holding onto a losing position, because taking that loss would feel worse compared to finding a way to get back to breakeven.

Here's how to use it in trading:

First, acknowledge that you have it. I wouldn't recommend trying to eliminate this feeling, but just be aware of it so you can adjust position size or bail on a position because you hate it.

Second, try to find ways to apply it to your analysis. I believe that much of technical analysis is trying to find who is in the trade and what they are feeling, and these feelings can be reflected in overall price action.


by Steven Place

Steven Place is the founder and head trader at