Mathematically Optimal but Psychologically Wrong

November 2nd, 2010

Here’s a good article that relates quite a bit to trading. John Cook discusses debt consolidation and the debt-snowball strategy. His point is that the even though it’s mathematically optimal to tackle higher interest rate debt first, in practice it’s more practical to tackle the smaller debt first.

There are a lot of parallels to trading with this. A good example is scaling out of trades. In most every strategy I’ve come across (and all that I’ve traded), the mathematically optimal strategy is to not scale out of trades but to keep your position until a stop or a target is hit.

In real life though this is often difficult to do. It only takes a couple trades where your target is oh-so-close to being hit and then ends up stopping out to see that scaling out could provide some psychological relief.

Another good example is using an optimal position size for your trades. Depending on your account size the optimal position size for your trading strategy might result in some really large drawdowns to weather. You have to take into account the psychological element – your theoretical backtest doesn’t care that it’s difficult to trade through drawdowns. 😉

4 Comments »

  1. HistorySquared Said,

    November 2, 2010 @ 9:35 pm

    in addition to the psychological benefit, such as making it easier to hold a piece for a large move, scaling out can lead to a smoother equity curve.

  2. Dave Said,

    November 3, 2010 @ 5:51 am

    That’s true, @HistorySquared. The only problem is that the slope is flatter – at least in my experience.

  3. HistorySquared Said,

    November 7, 2010 @ 2:59 pm

    came across a related quote

    “In fact, the ironic part of system design is if you want to maximize profits, you must be willing to give back a great deal of the profits you have already accumulated.”

    Van K. Tharp

  4. Pre-Market Study Hall StockTwits FX Said,

    November 7, 2010 @ 6:29 pm

    […] Mathematically Optimal but Psychologically Wrong (StockTickr) via @maoxian […]

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