Why do retail investors always buy high and sell low?
Why do they often choose to lock in profits but end up losing?
Why do major positive news lead to a spike in the stock market followed by a retreat?
Why do major negative news lead to a rebound in the stock market?
This series of questions is well answered by Nobel laureate Daniel Kahneman's prospect theory.
In the investment market, some people succeed by being friends with time;
some people make money by being friends with leaders.

Kahneman, however, proposed a new theory, which is to be friends with psychology.

Kahneman won the Nobel Prize in Economic Sciences in 2002, becoming the first psychologist, not economist, to do so. Traditional economics is based on the assumption of 'rational economic man': external factors determine human behavior.

However, Kahneman found during his research that purely external factors cannot explain the complex decision-making behavior of individuals; he discovered that internal factors are the key to determining behavior.

For example, the probability of winning the lottery is extremely low; if it were based on rationality, so many people would not dream of getting rich; the probability of car accidents is low, but most people are still willing to buy insurance, allowing insurance companies to profit.

Warren Buffett has repeatedly emphasized the importance of psychology in investing, famously stating: the biggest enemy of investors is often themselves.

In his representative work (Thinking, Fast and Slow), Kahneman also noted that Buffett's success comes from a deep understanding of market psychology, allowing him to identify and exploit opportunities created by others' irrational behavior.

In 1979, Kahneman proposed the 'prospect theory', finding through experiments that most investors are not standard investors but behavioral investors, with retail investors being a typical example.

Their behavior is not always rational, nor do they always avoid risks.

So, what secrets does Kahneman's prospect theory reveal?

First, the law of loss aversion.

Kahneman proved through experiments that the pain of loss is 2.5 times the pleasure of equivalent gains. This psychological mechanism manifests in the stock market as: retail investors tend to sell profitable stocks early while holding onto losing stocks for a long time.

When faced with unrealized losses, retail investors prefer to take risks and wait for a recovery rather than cutting losses. Why do people prefer to maintain the status quo rather than change? Because the psychological cost of potential losses is higher. When stock prices rise, as soon as there is a pullback, retail investors worry about profit retraction and quickly sell off, missing out on potentially greater gains.

However, when stocks are at an unrealized loss, many retail investors can hold on for years, ultimately facing massive losses.

As Kahneman said: people do not make decisions based on future gains but rather try to prove that their past choices were correct. Buffett's solution is textbook; in his 1987 letter to shareholders, he stated: if you find yourself in a hole, the best thing to do is stop digging.

Be fearful when others are greedy, and be greedy when others are fearful.

For example, the day after Lehman Brothers' bankruptcy in 2008, Buffett made a large purchase of Goldman Sachs, profiting handsomely three years later. This contrarian operation is a way to counteract the law of loss aversion.

Second, the certainty effect.
Kahneman once conducted a small experiment, asking people to choose between two options:
Option A guarantees $900;
Option B has a 90% chance of winning $1000 and a 10% chance of winning nothing.

The experiment showed that the vast majority chose option A. But when Kahneman changed the conditions to: Option A guarantees a loss of $900, and Option B has a 90% chance of losing $1000, the results completely reversed, with most people choosing to take the risk.

This is the certainty effect; Kahneman found that the psychological satisfaction derived from certainty far exceeds that of risk and reward. When faced with certain gains, people exhibit an extraordinary tendency to avoid risks, often becoming overly sensitive and fixated on locking in profits.

Institutional operations often go against certainty; for example, when encountering significant positive news, retail investors rush in or increase their positions due to the certainty of the positive news, but institutions often engage in contrarian operations, using this opportunity to offload shares, leading to a spike and subsequent retreat in the stock market.

Whenever significant negative news arises, because it is a certain negative, retail investors quickly sell and exit, while institutions often engage in contrarian operations to accumulate shares, resulting in the stock market often rebounding from a low.

Third, the reflection effect.

In the case of losses, people often transform from risk-averse to risk-seeking.

Kahneman's statistics show that when investors face a loss of 30%, the probability of averaging down surges by 200%, ultimately falling into a vicious cycle of buying more as prices drop.

Kahneman has a famous coin toss experiment: people believe that after tossing a coin and getting heads five times in a row, the probability of tails on the next toss increases, but in reality, it remains at 50%. Las Vegas casinos have also statistically shown that after seven consecutive reds, the number of people betting on black increases by 4.3 times.

In the stock market, the nine-turn rule states that when the stock market closes lower than the previous days for nine consecutive days, many retail investors firmly believe that value recovery is imminent, but they are often just facing a continuation of the decline.

Neuroscience experiments at Cambridge University provide evidence for this; when subjects incur consecutive losses, the activity in the prefrontal cortex (the rational decision-making area) diminishes, while the amygdala (the emotional center) sees a 300% increase in activity. This explains why retail investors always give up in the darkness before dawn.

Isaac Newton, the famous mathematician and physicist, lost most of his life savings in the stock market and then painfully stated: I can calculate the motions of celestial bodies, but I cannot calculate the greed of humanity.

Newton did not lose to intelligence but to human nature.

In the capital market, countless investment tragedies have occurred due to human weaknesses, and behind these stories lie deep psychological codes. The reminder from the head of Zhongjin in (Flourishing Flowers) is very pertinent: the heart can be warm, but the head must be cool.

Buffett has also said: the most important quality in investing is temperament, not intelligence. This statement is the best interpretation of Kahneman's prospect theory.

Because of loss aversion, we tend to panic excessively when the stock market falls; because of the certainty effect, we become blindly optimistic when the stock market rises; and the reflection effect ultimately leads us to irreversible mistakes.

Faced with these cognitive traps rooted in our genes, perhaps as Kahneman said: we cannot eliminate cognitive biases, but we can design systems to make mistakes costly.

The famous Medal Fund has been established for over 30 years, with an average annual return rate of 66%, outperforming all investors, and even during the 2008 global financial crisis, the Medal Fund still made an 80% profit.

The success of the Medal Fund is due to a rigid rule: everything must be traded using mathematical models, completely excluding human intervention, using thousands of data factors to replace human decision-making, which is the theory of quantitative systems.

Thus, in this irrational world, the true holy grail of economics is not some mysterious formula but a clear understanding of human weaknesses and institutional constraints.

Because victory in the investment arena does not belong to those who beat the market, but to those who tame the demons within themselves.

Let us encourage each other!