Dear Reader

Imagine as an investor, you have 2 options.

Option 1 is to walk away with a sure gain of R500. Option 2 would give you a 50% chance to gain R1000 and a 50% chance to gain nothing. Which option would you chose? Imagine now that you must choose between a sure loss of R500 or the alternative of a 50% chance to lose R1000 and a 50% chance to lose nothing. Take a moment and think about these two cases. Which option would you select in the “winning” scenario and which in the losing scenario?

A study just like this one was conducted in an attempt to understand the behaviors of investors when making profits or taking losses (Daniel Kahneman and Amos Tversky, 1979). The results of the study highlight some fascinating discrepancies between the different weights investors place on gains and losses. 84% of investors in the study chose the sure gain of R500, whereas 69% of investors chose to risk the chance to lose R1000 (double the amount) in order to avoid the sure loss of R500.These two problems actually pose the identical options to the investor in terms of net cash in his pocket. What is it about loss that causes investors to display such inconsistent behaviour?

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Why do we have to be such bad losers?

Investing in the markets would be far simpler if we lived in a world filled with rational, informed and consistent investors. But we don’t! We know most investors to be highly influenced by emotion, resulting in illogical and inconsistent investment choices. It is frequently the case that such behaviour can even undermine the long-term financial success of investors. While it is clear that people hate to lose, especially when it comes to money, it seems investors will go to great lengths to avoid making a loss. Somehow they rationalize that if they don’t sell, they can escape the loss – someday they might break even. Once they sell however, they cannot escape the fact that they have lost money. It is this thinking which so often results in the investor losing a significant portion of his net worth! For all these reasons I have long considered the primary weakness of most investors to be their inability to realize their losses. We all enjoy winning and we all take pain when we lose, but why do we have to be such bad losers?

Let’s attempt to better understand our attitudes towards loss. A series of studies has shown the loss of R1 is perceived to be twice as painful as the perceived pleasure received from the gain of R1. This helps to explain why investors are frequently willing to take more risks to avoid losses than they are willing to assume risk to realize gains. In fact, investors tend to become risk averse when faced with sure gain, yet become risk takers when faced with sure loss. This would shed light on the tendency of investors to sell their winners too early and hold onto their losses too long. When considering this objectively, we know the opposite to be wise investment advice – to cut losses and let profits run. However, we are all too familiar with the investor who sells stocks only if they have gone up, never if they go down. To add insult to injury, such investors often take on MORE risk once they are behind to try and recoup losses, sometimes even doubling down as the stock continues to drop.

A group of subjects was told to imagine that when they had arrived at a movie theatre they discover they have lost the theatre ticket. They were then asked whether they would consider paying another $10 to replace the ticket. A second group of subjects was asked to imagine they were going to a play, but had not purchased tickets in advance. When they arrive at the theatre, they realise they have just lost a $10 bill. Would they still buy a ticket? In both cases the subjects were essentially presented with the same scenario- would you want to spend $10 to see the play? In the most part this is exactly how the cash-losing group interpreted the issue, with 88% opting to buy the ticket. In contrast, however, the ticket losers, seeming to have focused on sunk costs, questioned whether they were willing to pay $20 for a $10 play. Only 46% of this group would consider purchasing the ticket! Loss aversion and a preoccupation with an already sunken cost dramatically affected the behaviour of this group. (Study conducted by Tvesrsky and Kahneman at Princeton University, 1984)
Issue#6, June 2009

Loss is part of the trading game

It is clear the behaviours described above are not conducive to making money, yet we (myself included) have all fallen prey to it at some stage or another. If we are all susceptible to such behaviour, we must determine ways in which we can immunize ourselves from repeatedly behaving in this manner. So, how do we better protect ourselves? The first step is probably the easiest, and that is to understand our psychological need to avoid losing may be compromising our objectivity. We may convince ourselves that we have legitimate reasons to sell our winners and hold onto our losers, but in all likelihood we are just fooling ourselves. Rather, we need to internalize the notion that loss IS part of the trading game, and while losses hurt, they are inevitable. If we are able to steal ourselves away from panic when losses happen, we can underplay their ability to make us feel like we have failed when they do. Once we have restructured our beliefs about losses, we can better accept the possibility of a loss without tremendous pain, and though this might sound corny, we can unravel the negative cycle of pain so many of us have been caught in – particularly of late!! The sooner we can grasp all of this and apply it, the easier it will be to achieve the next step in the process. This is certainly the more challenging one – the identification and execution of a (necessary) losing trade.

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Why you must watch out for my special MoneyMorning bulletin at midday today

When I first began this article, I never anticipated that the topic would be such a sizeable one. I have been giving these ideas a tremendous amount of thought as I believe they touch each one of us in some way or another. In the next issue, I intend to examine how best we can deal with our losses from a practical trading perspective. What are the parameters and rules we should set to mitigate these losses? I look forward to sharing these thoughts with you and in the meantime, when it comes to losing, I sincerely hope we can all be better sports!!

Later today I will be sending you more on a different type of analysis that completely discounts any form of emotion. I urge you to read this special bulletin – of MoneyMorning – it should be in your inbox around midday.  The type of analysis I share with you in this bulletin has definitely helped save my bacon on many a trade and some of the well timed signals have yielded fantastic profits.

Be sure to check out my bulletin at midday today.

Yours in investing

Yonaton Rom
Technical analyst, The Winning Edge

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