Investment Psychology: Decoding FOMO and Loss Aversion and Building Antifragility Through Systematic Trading Rules

Abstract

Although the stock market seems trading-free, millions of untrained retail investors lose money due to some psychological barriers. Drawing on Kahneman’s dual-process theory and Taleb’s framework of antifragility, this paper argues that the core problem of retail trading is not a lack of information but the distortion of judgment by FOMO, loss aversion, and related cognitive biases. It further proposes that a set of systematic trading rules — covering entry and exit criteria, position sizing, stop-loss thresholds, and a trading journal — can contain these biases and help retail investors move from psychological fragility toward antifragility in volatile markets.

Introduction

In recent years, with the rapid development of the digital financial trading market, it is increasingly easier for ordinary people who haven’t been systematically trained in trading and investing to participate in financial markets. On the surface, it seems like the capital markets offer us a fair opportunity to join a game of chasing fame and wealth. However, is that the truth so explicit? As research reveals, individual investors pay a tremendous performance penalty for active trading, and their net returns significantly lag behind the market benchmark due to transaction costs driven by overconfidence. Two primary factors why the dilemma of the more you trade the less you earn are FOMO mindset and Loss Aversion.

To decipher the secret of investment psychology, my research focuses on the intersection of psychology and finance. Previous behavioral research often lacks operability. Many of those theories sound plausible, but do not work on our daily trading actions. To address the gap between theories and real transactions, I commit to giving a systematic solution by developing a market-monitoring and psychological-alert framework.

I use a literature-based analysis method, combining my own investment experience. It covers the realm from behavioral psychology to finance, analyzing common psychological patterns in retail trading and proposing rule-based coping strategies. This paper does not conduct formal trading experiments, nor does it use personal real trading records as core evidence. The remainder of this paper is organized as follows: Section I reviews three books in related fields; Section II lists representative psychological barriers in trading; Section III gives comprehensive systematic solutions, treating both the symptoms and the root causes; the last two sections summarize the whole paper and point out the flaws in it.

I. Literature Review and Theoretical Framework

In order to conduct this research, I read the main materials shown below: Antifragile: Things that Gain from Disorder, The Black Swan: The Impact of the Highly Improbable, Thinking, Fast and Slow and some other papers.

1.1 Thinking, Fast and Slow

Thinking, Fast and Slow showed that we all have a dual system in our mind — the fast thinking system (System 1) and the slow thinking system (System 2) (Kahneman, 2011).

  • System 1: which is the representative of thinking fast intuitively and emotionally. It always relies on heuristics and associative memory. From the process of evolution, it is very necessary to have System 1, for it can save the energy our brain consumes, and raise the efficiency of food.
  • System 2: which mainly represents slowly rational and analytical thinking. In the narration of the author, System 2 is described as a lazy supervisor. It is always treated as the origin of our ego awareness. Though we always think most of our decisions are well-considered, System 2 hardly plays a role when we determine our mind.
  • Loss Aversion Mechanism: Kahneman also reveals a key finding in this book, which is that the pain we feel when we lose an equal amount of money is much bigger than the happiness we feel when we earn it (Kahneman, 2011). It could help us reveal why retail investors prefer to keep stocks that are not performing well in hand instead of admitting loss and leaving the game.

1.2 Antifragile

A key concept in this book — antifragile — is presented by using concepts to compare. In this book, Taleb raised the comparison between fragile and robust at the beginning, then turns out that the opposite side of fragile is not robust but antifragile. Antifragile is not equal to robust, either. Robust doesn’t like volatility, while fragile cannot afford volatility, and antifragile can benefit from volatility (Taleb, 2012). The dialectical relationship of the three-dimensional subject is an insightful way for us to learn more about antifragile.

To further make antifragile work for us, Taleb (2012) gives us these three strategies:

  • Barbell Strategy: hedging your bets. While managing your asset, you should use 90% of it extremely conservatively, and 10% of it aggressively.
  • Via Negativa: sharpen your mind by reducing those unnecessary things in your life. Reducing those things you don’t know well is a key way to clean out the fragile side of your life. It can also enhance antifragility from the opposite direction.
  • Tinkering: tinkering is a low-cost but high-profit action. On one hand, you don’t pay too much in tinkering. On the other hand, you successfully reduce uncertainty and fragility in your life. It is a good deal from many perspectives.

1.3 The Black Swan

The Black Swan is also a book that reveals the charm of uncertainty. Through this book, Taleb tells us there is another Extremistan world beyond our cognition (Taleb, 2007).

Before the discovery of black swans in Australia, Europeans didn’t think there was a swan in the world other than white. That is why the book is so named. The book is dedicated to telling us we must escape from the trap of empiricism. The Black Swan event has the following three characteristics:

  • The Black Swan events are mostly unpredictable values. They never happened in history. No convincing precedent can be found in past experience and historical data.
  • They might cause extreme impact on society, history and even personal life. Just like the Internet Wave, the 2008 financial crisis and the AI Era.
  • Though the Black Swan events cannot be predicted, people would post-hoc rationalize them, making them just like avoidable and predictable events.

Two most impressive concepts in this book are Extremistan and Mediocristan.

  • Mediocristan: the aspect the world shows us most of the time. It is consistent with normal distribution. Mediocristan is lacking in uncertainty and volatility. It is predictable but also lacking in opportunities.
  • Extremistan: the main discussion object in this book. Extremistan is a metaphor for a world of uncertainty. It is dangerous for those who search for certainty, but full of opportunities for those who want to surf in the volatility.

Because the capital market is a best example of Extremistan, we cannot chase a certain revenue target. The only way we can let ourselves benefit in the capital market is by navigating uncertainty, making it work for us. The goal is not to eliminate fluctuations, but to build systems that can learn from and improve upon them.

II. Psychological Barriers in Retail Trading

2.1 The FOMO Mindset

Definition: FOMO is the abbreviation of Fear of Missing Out, which is very common among retail investors. It is the mindset referring to retail investors being afraid of missing out on upward opportunities.

Behavior: When a stock soars immediately, a retail investor cannot help but buy it. In China A Shares, it is particularly common due to its characteristic of a higher percentage of retail investors. The pain of missing a soaring stock is even greater than the loss in our mind.

2.2 Loss Aversion

Definition: Loss Aversion means people are more sensitive to loss than to profit (Kahneman, 2011). If you give someone $1,000 and he/she loses $100, finally getting $900, this person would be happier than if you initially gave him/her $900.

Behavior: Investors are overly sensitive to losses. Many retail investors are unwilling to cut losses and prematurely sell profitable assets.

2.3 Cognitive Blind Spots

With the combination of greed, confirmation bias, and the two psychological factors mentioned above, many retail investors exhibit investment behavior that is a mixture of irrationality and chasing hot spots (Kahneman, 2011). What is even worse is that these disadvantages can cause a reverse flywheel effect, making many retail investors stuck in a vicious circle of — losing money, then being eager to recover losses, then continuing to chase hot spots, and finally losing even more money.

III. Building Antifragility Through Systematic Trading Rules

After knowing there are so many human weaknesses lying between us and getting returns from volatility, the following steps are trying to resolve them. From the books I read, I refine these theoretical frameworks.

3.1 From Intuition to System

So far, many retail investors are relying on their intuition to invest. The only reason why they buy stocks is that they recognize the stocks would rise. To avoid being infected by our sudden emotion, one of the best solutions is setting a systematic strategy for ourselves.

Some of the recommended strategies are entry criteria, exit criteria, position sizing, stop-loss rules, maximum loss per trade and trading journal. An objective, rule-based system operates outside the control of emotion, which is not just antifragile but also gets rid of the flaws of human nature in trading (Kahneman, 2011).

3.2 Embracing Non-Consensus

The market is running under billions of normal people’s daily actions. So the flaws of human nature I mentioned above exist not just in non-trained retail investors, but are also projected onto market fluctuations through their every action. To become a smart investor, we can utilize this flaw, buying an undervalued but really valuable asset, then selling it after the market rediscovers its value.

3.3 From Fragility to Antifragility

Going from a fragile investor to an antifragile one doesn’t mean we can easily earn profit from the market. It means we should transfer from being a victim of market fluctuation to a surfer of the market wave. Antifragile investors can improve their systems from mistakes and fluctuations (Taleb, 2012). The significance of systematic trading rules is not to ensure correctness, but to make errors controllable, recordable, and repeatable.

IV. Discussion and Limitations

However, the theoretical analysis cannot cover all real-world circumstances. The systematic rules cannot ensure a high profit. They can only reduce the influence of psychological bias. Empirical research is necessary for further exploration. My research is still stuck in pure theoretical research. In the future, I will include real-world scenarios and controlled experiments, figuring out how the psychological factors influence people’s investment decisions. To reach this goal, I will add real trading logs, simulated trading data or historical market cases. Some investors can earn high profit in totally reverse ways. They use quantitative trading rules and programs, just following the human flaws. Their secret is the fastest execution speed, finding the emotions and the market’s temperature at the beginning and executing trading right after the signals appear. Those trading rules are hard to copy and have very high risk. The trading system I want to develop must serve the stability of our own financial system rather than chase the highest profit.

V. Conclusion

In this paper, I started from three books I read about finance and psychology, then used some specific methods to delve into the intersection of trading and investors’ common mindset. After identifying the problems, I discussed how to avoid falling into the trading traps by building systematic trading rules, and finally acknowledged the research deficiencies and limitations. During millions of years’ evolution, we have evolved some unique psychological mechanisms like System 1 and System 2, loss aversion, and cognitive blind spots. But in the modern financial market, these survival strategies become negative impacts on us. What’s more, the market is a world of Extremistan, which is full of uncertainty and beyond our prediction. Luckily, those psychologists and financiers gave us some useful advice in their books. By combining several of these approaches with my own insights, this paper argues that systematic trading rules, though unable to guarantee profit, can transform impulsive trading into a recordable and reviewable process, helping retail investors move from psychological fragility toward antifragility.

References

Barber, B. M., & Odean, T. (2000). Trading is hazardous to your wealth: The common stock investment performance of individual investors. The Journal of Finance, 55(2), 773–806. https://doi.org/10.1111/0022-1082.00226

Kahneman, D. (2011). Thinking, fast and slow. Farrar, Straus and Giroux.

Taleb, N. N. (2007). The black swan: The impact of the highly improbable. Random House.

Taleb, N. N. (2012). Antifragile: Things that gain from disorder. Random House.