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martes, 2 de septiembre de 2014

The Nirvana Fallacy in trading

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Unknown by most, the nirvana fallacy is the logical error of comparing real situations against utopian, unrealistic and idealized situations. Alternatively it can also refer to the tendency to assume that there is a perfect solution to a particular problem.

This term was coined by economist Harold Demsetz of Chicago School in 1969 and stated that:
The view that now pervades much public policy economics implicitly presents the relevant choice as between an ideal norm and an existing 'imperfect' institutional arrangement. This nirvana approach differs considerably from a comparative institution approach in which the relevant choice is between alternative real institutional arrangements.
Or as Voltaire would say, "Le mieux est l'ennemi du bien" ("The best is the enemy of the good").

Surely this concept is not so easy to understand, but surely a simple example will clarify it for the reader. Imagine that you recently had a knee surgery but has not been perfect and still has some discomfort. Then, you go to the doctor thinking that a new operation will solve the problem, but after analyzing the problem, you are recommended not to operate because the outcome can be counterproductive and even give away with the current enhancement. That is, we believed that an operation would solve our problem and let our knee perfect when in fact the situation would have deteriorated sharply.

Can this type of fallacy affect our trading? I leave the reader to infer the answer after examining these thoughts that time to time come from the traders mind:

"I closed my position winning 30 pips and, of course, the market rose some 30 others. I have to think how to capture that extra movement from now, I left 300o USD on the table".

"Last year I won 40% but a friend of mine obtained 125%. My goal next year is to surpass him." 

"I am doing so well lately in trading that I am thinking to increase leverage to increase profitability."

"This trade is moving exactly as expected and will earn 15%. My exit goal is 2% away but they will close the market and ... I think I'll keep this position until the opening tomorrow."

Would these ideas sound familiar? All phrases above have in common that pose a false dichotomy in which an option is clearly more advantageous, while it is much less likely. Of course our logic clouds to the great advantages of this option which is the one we chose, even knowing that this choice is not the best and possibly make us lose the account. 

When you intuit that your judgment is clouded by the nirvana fallacy, remember: the only difference between the various traders participating in the market is the magnitude and frequency of their victories and failures, the rest does not really matter. 

Good luck in trading!




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