One of the most difficult things for market participants to do is to admit that we are wrong and take a loss. We all know that one guy who has held stock XYZ since $100 as it spent years trading lower, only to find its final resting place in the single digits, or worse, delisted / bankrupt. Or that guy who moves his stop, or removes it altogether, because “the market is wrong”, only to end up holding a handful of worthless options at expiration (yes, I’ve been there). In hindsight, all of these actions sound absurd, but in the heat of the moment when emotions are flaring, it can be difficult to make the most appropriate decision.
So why is it that so many market participants go to such drastic lengths to avoid taking a loss?
Well, as human beings, we all deal with something called loss aversion. In its simplest form, loss aversion refers to the tendency of people to strongly prefer avoiding losses to acquiring gains. Now I know most twitter traders don’t have to deal with this type of situation, but for the rest of us, it is a frequent occurance.
Having a plan that addresses how you’ll handle taking losses, as well as any other scenario you can think of, is one of the ways to limit the mistakes that may be caused by loss aversion and other behavioral biases. If you’re comfortable with your trading plan, executing it should be almost mechanical in nature. The more specific your plan, and more comfortable you are with executing it, the higher the likelihood that you can avoid falling into the many psychological / behavioral pitfalls we are all susceptible to.
Loss aversion is an important concept and he best way I know to drive it’s impact home is to leave you with one example of my run-in with it in a trading context.
Yesterday, two positions I had put on in the simulated portfolio I’m running were at their stop loss level. It was approaching the close of trade and I knew that I should be exiting them as that’s what my process calls for. However, since both positions were “just barely” at my stop loss and were set to close off their lows, I had thoughts about letting both run into today to see whether or not they’d turn around. These are thoughts traders have everyday, but ultimately I cut my position in EWM for a less than 2% loss and my FXA position for a loss of roughly 60 bps. Today, EWM went higher without me and FXA continued lower. In both cases, my stop did exactly its job; to get me out of a trade where my thesis was no longer valid.
Also, you know how I mentioned that we feel pain from losses much more than pleasure from gains, think about this. It was still difficult for me to these take those losses despite them being offset by gains 3x the size in my other trade, AND the fact that it’s a paper trading account. If that isn’t a ringing endorsement of what loss aversion looks like, I don’t know what is.
The moral of the story is this: We’re all wired with these behavioral flaws built in, so it’s important to familiarize ourselves with them and create a trading or investing strategy that limits their ability to negatively impact our returns. Easier said than done, I know, but let’s give it a shot for all our sakes.
As always, if you have any questions feel free to reach out and I’ll get back to you as soon as I can.