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 loss aversion in trading again and again with new traders. But this isn’t something you hear about with 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. You know how you hear the phrase “learn from other’s mistakes?” This is one of those times that we really hope you can learn from ours and the thousands of traders that have come before you. We’re going to aim to get you through this one as quickly as possible, because, frankly, it is trading’s most important lesson. If you can’t learn this one, it’s going to be expensive!
If you were to throw a dart at a list of stocks, the universe would dictate that you’d hit a few winners and a few losers. So how do you turn that mishmash of results into a profit? 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. Worse yet, it is not the least bit helpful in trading.
The stock market doesn’t care if your feelings are hurt. In trading, the truth is brutal, and lessons are learned the hard way. By not accepting a small loss on a stock trade, that often means we will eventually be forced to accept a much larger loss. I don’t know about you, but I don’t much like being forced to do anything.
So let’s see this play out…
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?
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.