The Truth About Hyperbolic Discounting in Trading & How to Overcome It
Stock traders experience hyperbolic discounting in many ways, often without realizing it. Here are the most common examples to be aware of:
1. Cutting Winners Short
Traders often exit profitable trades too early because they want to “lock in” their gains, even when their trading system signals they should stay in the trade. This prevents them from maximizing profits.
2. Chasing Quick Wins Over Sustainable Growth
Hyperbolic discounting leads traders to favor high-risk, high-reward strategies, such as over-leveraging or trading without a backtested strategy because they want fast results. This usually ends in losses.
3. Ignoring Long-Term Trading Plans
Instead of following a systematic trading strategy with proven long-term results, traders get distracted by short-term market movements, financial news, or social media “hot stock” tips. A seminal research paper on hyperbolic discounting found that individuals have high short-term discount rates and lower long-term discount rates, which leads to self-control problems, causing them to not be able to stick to a long-term strategy.
4. Revenge Trading After a Loss
After a losing trade, traders often feel an emotional urge to “take back” their money quickly. This results in impulsive trading, which typically leads to further losses.
Consider a trader who spots a promising setup in a mid-cap stock showing signs of a major trend reversal. Their analysis suggests a potential 40% gain over three months, but within just two days, the position is up 5%. Despite their conviction in the larger move, they close the trade, content with the quick profit.
Without realizing it, traders fall into a cycle of short-term thinking that prevents them from reaching their full potential.
