Why people trade with losses - Prospect Theory and Poker

Traditional finance theory is based on the assumption of efficient market and rational players. With the effort of many dedicated economists, the framework of modern finance has been established. The revolution of financial engineering further provides us deeper understanding on exotic derivatives pricing, risk management, and a wide array of proprietary strategies used by hedge funds and prop desks. However, the theory does not explain the fact that some people trade with negative expectation of return, such as lottery ticket and slot machine. The anomaly does not agree with the "rational players" assumption. If it is an irrational behavior, why people still do it even they realize the case?

Prospect theory, developed by Daniel Kahneman and Amos Tversky, is one of the fundamental theory of behavioral finance. It shows individuals have different prospects for gains and losses. In other words, one's happiness does not increase with gains in the same speed as one's unhappiness grows with losses. A couple visiting Las Vegas for Christmas may feel somewhat indifferent with $100 and $200 gains, but may feel more grieved with $200 losses than $100.


In poker, one need to be patient enough to be profitable consistently. Never look for a quick profit with high risk, which usually has negative expected return. I have been wondering why someone consistently collects profit at our regular Friday poker party. As a rational player, I identified some players called others bets even they knew they had a small chance to win. They bet at uncompetitive odds because they receive utilities other than expected profit, which is playing the game instead of watching. I usually do not mind watching, and provide a small "fold"ing profit to bluffers, which encourage them to gamble loosely and enjoy their smart bluffs. Then as the time comes in, I take a large gain with good hands.

Trading is a zero-sum game

Trading is a zero-sum game. Traders must trade with people who will lose to become profitable. Profit-driven traders therefore must understand why losers trade to know when they should trade.


Profit-driven traders trade only because they rationally expect to profit from their trades, including speculators and dealers. Utilitarian traders trade because they can obtain some benefit from trading besides trading profits. Investors move money from current to future. Borrowers move money from future to current. Asset exchangers need to exchange assets. Hedgers want to lower the risk. And gamblers trade for the joy of trading. The profit-driven traders are rational, and they theoretically profit from providing the utility to the utilitarian traders. Identifying a general utility need is very helpful to identify opportunities. In the 2008 crisis, banks deleverage and few people have cash. It is the perfect time for Berkshire to make strategic deals as they are flushed with cash. In this sense, it is good to be different.