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Expectations Trading: Mathematical Expectation Is Key for Trend Following

In Peter Bernstein’s book, Against the Gods: The Remarkable Story of Risk, he briefly explores ‘Prospect Theory’. He outlines an experiment in which it is shown that ‘our choices between negative outcomes are mirror images of our choices between positive outcomes’.

Suppose in experiment (1) you are offered the choice between US$3000 for certain and an 80% chance of US$4000 or 20% chance of nothing. Even though the risky choice has a higher mathematical expectation, 80% of those surveyed chose the US$3000 for certain. The vast majority was risk averse.

In the second experiment (2) you have a choice ‘between taking the risk of an 80% chance of losing US$4000 and a 20% chance of breaking even versus a 100% chance of losing US$3000. Now 92% of those surveyed chose the gamble even though the mathematical expectation says you should take the certain US$3000 loss’.

This is the crux of trading like a trend follower. If you want to be a part of the majority that when faced with a choice of loss you continue to seek risk – forget it – you are doomed to failure.

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