We like to think that humans take decisions in a rational and logical way, like computers do. Most economists model the consumer as a rational being, a consumer that makes well informed rational decisions.
This rational consumer is the basis of every market with supply / demand fighting for every consumer. In this 'perfect' situation, we would have consumers select companies, products, services etc that are best in every aspect and fit their needs the best. Whether those short term results are any good for an economy as a whole, or the environment and other (long term) aspects is something to discuss in another article.
So humans aren't the rational beings they claim to be? There's a beautiful quote from the book "Mean Markets and Lizard Brains - how to profit from the new science of irrationality" by Terry Burnham (it's in my bookstore). The author writes about an incident and then concludes with "Is such irrational behavior common? Yes. People are crazy." Behavioral economists have proven that our financial decisions are often irrational.
The author then uses the term lizard brain to describe that part of our brains as the part that reflects the world of our ancestors. This lizard brain has helped mankind to survive through evolution, but it's a backward looking system not very suitable for the financial markets. The lizard brain makes us buy high and sell low. We do have a rational part in our brain, but especially in financial markets, the lizard part is very often the stronger one and causes irrational behavior.
The lizard brain causes us to be stubborn and not accept a loss, thus resulting in a much bigger loss. In trading, this means using a stoploss. You can be stubborn and hope for the markets to turn around and come your way. But until that happens, your loss will increase and you may be forced to close the position after all.
Second, the lizard brain hates a loss more than it likes an equal gain. The author refers to an experiment from Professor Kahneman. In the experiment, the player flips a coin. If the player loses (50% chance), he has to pay $5, if he wins, he takes the jackpot. How much would any player want in that jackpot to accept the gamble? The average answer is $10. Rationally, any amount above $5 would make it an attractive gamble, but the lizard brain is interfering again. It wants a significant compensation for a potential loss.
Third, the lizard brain likes to discover patterns in random events, it likes a logical explanation for random or illogical events. The world famous psychologist B.F. Skinner was able to develop superstitious pigeons. Food was provided at regular intervals, but the pigeons thought that their specific behavior had anything to do with it. The next food interval would then reinforce this behavior.
So in trading, switch off the lizard brain and don't become a pigeon.
Fair and unfair randomness: Does your brain accept randomness?
A flexible mind: Don't be nice to your ego