*****David Blair, The Crosshairs Trader, is a blogger/trader/educator who does a wonderful job of sharing research on elite performance and how it relates to trading. Below is his latest post for the SMB trading community.***** — Editor’s Note
Key Point: We will do anything to avoid a loss even to the point of ignoring that we have one, while claiming any small gain as quickly as possible just to say we had one.
We have all heard it said … let your winners run and cut your losers short… but understanding and then accepting it is quite another matter. We may hear it and we may read it and we may nod our heads in agreement but do we really know how to let our winners run and cut our losers short? It is easy to understand but very difficult to apply. Rest assured there is a really good reason why it is so difficult and why most of us fail at it. The thought is golden; it’s application elusive. Of course, the academia have a term for our difficulty in applying the thought to our actions. They refer to it as loss aversion. Our actions define it for us. We have a stronger tendency to avoid losses than we do to acquiring gains. In other words, if we had a choice between avoiding a loss versus acquiring a gain the former wins out more often than the latter. No where is this more prevalent than in the stock market. We will do anything to avoid a loss even to the point of ignoring that we have one, while claiming any small gain as quickly as possible just to say we had one. Of course, this turns “let your winners run and cut your losers short” on its head as we let the losers run in hopes of eventual victory while cutting the winners short before they have a chance to claim a prize in the winners circle.
The following resources should help us all work on applying our well intended thought to solid action.
Loss aversion neatly explains the phenomenon known as the endowment effect, the tendency for people to place a higher value on something they own than on an identical thing that they do not own.
An implication of the endowment effect is that people treat opportunity costs differently than “out-of-pocket” costs.
Loss aversion drives people to simply look away from losses.
We’re willing to leave a lot of money on the table to avoid the possibility of losing.
When we invest based on emotions, we can make bad decisions — decisions that can lead to loss.
Studies show we experience twice the emotional impact of a loss compared to any pleasure we feel from an equivalent gain.
Loss aversion is an important factor in more decisions than we probably realize.
Every good feeling you get from gains will get completely wiped out by the terrible feelings from the down days.
People strongly prefer avoiding losses to seeking potential gains.
Now let’s get to work on not only on our winning but on our shorting.
THE CROSSHAIRS TRADER
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