In his book Thinking Fast and Slow, Dan Kahneman makes the point that, because “thinking is hard”, we rely on mental shortcuts. Both Penny and Nick resist the idea of hedging because they feel it is too difficult. Yet risk management should be a central concern for any share trader and hedging is a valuable tool for this.
This can be even more harmful than the ways in which intense emotions shape our decisions. This avoidance of negative emotions may underlie some of the denial of risk indulged in by senior bankers in the lead-up to the financial crisis.
A feature of hedging is that in exchange for limiting risks within your current portfolio it reduces potential profits. Unwillingness to hedge can also be driven by unrealistic ambitions about the possible returns. Combined with an emotional aversion to market risks, this is a dangerous mix.
A characteristic of top traders is the capacity to face up to risk and make realistic appraisals. This self-discipline was reinforced by the role of managers in policing risk limits and monitoring trading positions where appropriate. For the private investor lacking such support, the challenge of managing risks is greater.
The emotional reaction to consideration of market risks can lead to an inability to trade.
Alternatively, the emotional reaction to market risks can drive a tendency to downplay or ignore risks — resulting in trading with no clear risk-management strategy and greater risk than you are willing to bear.
This article originally appeared on telegraph