One part of the book that I found particularly fascinating was the following hypothetical example. Imagine you are given a choice between these two options:
- Option #1: You are offered one million dollars, in cash on the spot, with no strings attached
OR
- Option #2: You are offered a 95% chance of winning two million dollars, but a 5% chance of winning nothing at all
Kahneman explains - and I'm sure you feel the same way - that pretty much everyone who is asked prefers the first choice, which is rather odd seeing as how the second choice offers a much higher expected value. Any purely rational person should, in fact, select option #2.
Here is the same example as above, but with a trend following twist:
- Option #1: You are sitting with a large open profit on a stock you bought recently. You can lock in the profit immediately and be 100% sure you will capture this gain
OR
- Option #2: You are sitting with a large open profit on a stock you recently bought. If you continue riding the trend higher, chances are that your profit will grow even larger, but at the same time there is a small chance that this profit will disappear in a flash and you'll end up with nothing
Again, most traders are going to do option #1. It's just human nature to lock in profits rather than take a chance with them. The job of the successful trend following trader is to fight this urge and let profits run until the trend ends, no matter when that may be.
"While amateurs go broke by taking large losses, professionals go broke by taking small profits. The problem in a nutshell is that human nature does not operate to maximize gain but rather to maximize the chance of a gain."
-William Eckhardt
