Risk Management — Loss Aversion

Avoiding Your Loss Aversion

Loss aversion is the well known phenomenon that explains why our brain assigns more negative weight to losing $100 than it does positive weight to a $100 gain. Because of this we find ways to avoid accepting the loss. In trading we tend not to consider a trade a loss until we actually close it at a loss, thereby creating the illusion that we haven't lost anything. If it's still just a loss on paper our brain can avoid the unhappy feeling of loss.

At what point is enough enough?

"I can't sell that, it's already down 50%."

We see this again and again with new traders. But this isn't something you hear from experienced traders—the traders who have been around a couple decades have long since learned the lesson of cutting off the losers. But taking a loss is not a lesson that comes easy to anyone. It's a hard fought lesson learned, and one that we hope we can get you through quicker than others, because, frankly, it is trading's most important lesson.

If you were to throw a dart at a list of stocks you would hit a few winners and a few losers. Now, how do you turn that mishmash into a profit? Simple enough, you cut the losers off quickly and let the winners run. Sounds simple in theory, but in practice our brains aren't wired this way. Study after study has been done that shows we are more inclined to cut winners off early and let losers run! It's maddening, but true, and is not the least bit helpful in trading.

The stock market doesn't care if your feelings are hurt. In trading, not accepting a small loss often means we will eventually be forced to accept a much larger loss.

So what happens?

  1. You enter a trade without a plan. You buy at a random price, and you have no clear plan (stop loss) in place to protect your downside risk. So when the stock drops 1% you shake it off. Down 5% you're worried, but are sure the market is just stupid—you've read some things about this company and are sure it's going to turn around. Down 15%, this is ridiculous, you double down. Down 25%, you hope it goes back up. Down 40%, don't ever mention it again, just pretend like that stock doesn't exist in your account. Convince yourself that someday it'll go back up. Now it's just a buy-and-hold position, that's all.
  2. You enter a trade with a plan. You know where your stop is. Maybe your stop is down 4%. But then one morning the stock gaps down on the open due to some bad news and is down 8%. Surely this is overdone, the news wasn't that bad. It will come back. Then it's down 15%, and you think wow, this is cheap now, I'm buying more. Down 25%, you hope...

You get the picture. Our minds are hard wired to never admit we are wrong. They are also wired not to sell something for less than we bought it for.

But what happens when that is the exact opposite of sane profitable trading behavior?

Sometimes trades go wrong. There is no way around it. Breaking this cycle of thinking that every trade needs to be a winner, or that a losing trade is a personal affront to your intelligence, is the hardest thing a trader has to learn. But learn it he must.

Book your losers, book your losers, book your losers. Don't allow them to run away on you. It's a mantra that should be repeated daily.

In trading you don't have to be right all that often. What you need are a few big winners, a bunch of small winners, and inevitably, a bunch of small losers. What's missing? Big losers. If you can avoid big losses, then profits will come naturally, almost mathematically.

So, what do we do to avoid big losses?

  1. Never enter a trade without knowing exactly where your stop is. Look at a chart, find support levels, trendlines, anything that says to you that below this level my idea for this trade is wrong. There is some point on every stock chart where you should be able to say, "This is a mistake."
  2. Always enter a stop loss open order. You've determined where you know the trade is wrong, so now place the order that takes the decision making out of your hands. Place a stop order a few pennies below that price, enter it as an open order, and don't touch it. If the stock moves against you, the stop will trigger, you'll take your small loss, and you'll move on.
  3. Once a trade is profitable move your stop up. Psychologically there is almost nothing more devastating than watching a winner turn into a loser. Those are the trades that freeze traders up. Once you have had a paper profit your mind says you are entitled to that profit, so as the stock keeps dropping you tell yourself that you will exit as soon as you can have that profit back. And it never comes. To avoid this, once you are up a certain level, we generally use 2-3%, move your stop up to break-even. Once you know you can't lose on a trade it's much easier to allow it to work towards your target price. Move the stop up regularly as the stock rises to ensure a nice profit on the trade when it inevitably turns lower.

Risk management is the key to successful trading. Master that and you will soon be watching your trading account grow. Have a plan for your trade and execute that plan with prudent use of stop orders. Profits are sure to follow.

Happy trading.

 

Photo by Alex Guillaume on Unsplash