Imagine you are given £50 with the following options:
Option A: Keep £30
Option B: Gamble with a 50/50 chance of keeping the entire £50 or losing it all.
Which option would you choose?
Now, consider the same situation from a different perspective. You are again given £50, but this time:
Option A: Lose £20
Option B: Gamble with a 50/50 chance of keeping the entire £50 or losing it all.
What choice would you make now?
Interestingly, most people exhibit risk-averse behavior in the first scenario, opting to keep £30. In the second scenario, however, people tend to act in a risk-seeking manner, with many choosing to gamble the £50.
Both of the above scenarios provide the same outcomes, but the second scenario is framed as a loss, which triggers different emotional responses in people, and can cause people to engage in risk seeking behavior in order to avoid the loss. This is due to a term in behavioral science called loss aversion.
What is loss aversion?
Loss aversion is the tendency for losses to feel disproportionately more impactful than equivalent gains. For example, our brains perceive losing £10 as significantly more painful than the joy derived from gaining £10. Neuroscientific research indicates that our brains process losses approximately 2.5 times more intensely than gains, leading us to fear losing more than we value winning.
In trading, this fear of losing can cause traders to drift away from logical and rational behavior, and instead lead to impulsive and emotional decision making. This can result in costly trading mistakes such as:
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Cutting winners too quickly: Once a trade becomes profitable, selling it immediately, due to fear of losing gains
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Letting losers run: Irrationally holding onto losing positions for too long, in the hope they will rebound and become profitable, just to avoid experiencing any loss
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Emotionally increasing position size: Doubling down on losing trades in an attempt to recover losses rapidly.
In general, losing often causes traders to become more risk seeking in an effort to avoid the painful feeling of loss again. There are two key cognitive biases can help us to understand and manage the emotional impact of losses and losing streaks in trading.
Behavioral Biases Contributing to Losing Streaks
1. Status Quo Bias
Human beings typically don’t like change, so we tend to stick with our existing decision making processes or strategies. Even when a new option or direction becomes available that is more beneficial to us, the Status Quo Bias makes us inert, preventing us from adapting to new information or improving our trading approach.
Examples of the Status Quo Bias:
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We stay with our current car insurer even though a new company offers better benefits.
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We use the internet browser that is preinstalled in our laptop, despite more efficient alternatives
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We stick with a trading strategy that has been generating consistent losses.
2. Sunk Cost Fallacy
If we’ve invested resources such as time, money, or effort into a decision or action, we find it difficult to then abandon it, even when it’s obvious it’s not a beneficial choice for us anymore. We don’t want to “lose” the money, time, and effort we’ve already invested, so we force ourselves to stay with it because of the emotional attachment. This irrational way of thinking is known as the Sunk Cost Fallacy.
Examples of the Sunk Cost Fallacy:
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Think of the number of times you’ve watched a film, hated it halfway, but continued watching until the end
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Think of the craze surrounding the Facebook game Farmville a few years back-people continuously logged back in to see their farms harvest, and they stayed coming back because they didn’t want their investments to die and then feel like they wasted their time.
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Think of all the time you’ve stayed in a losing trade for too long.
Strategies to Overcome the Status Quo Bias and the Sunk Cost Fallacy
So how do we combat all this brain behavior? We cannot get rid of cognitive biases they are ingrained in our subconscious and happen automatically. We can learn to recognize and understand them, which then allows us to create strategies that minimize their negative impact on trading decisions, cultivate better trading habits, and make more informed, rational decisions.
1. Reframe Your Trading Decisions
Remember the problem at the beginning of this article? Two different ways to frame the same question, one that activates our loss aversion and one that doesn’t. By altering the way you perceive your trading decisions, you can reduce the influence of loss aversion.
Instead of viewing things from a sequential manner, remove yourself and look at the scenario as isolated, and then see what you would do. Instead of asking “Should I get out of this long position?” ask “Would I short right now?”. If the answer is yes for the latter question, it should be a possible yes for the first question too.
2. Analyze Losing Days Rationally
On days when you incur losses, instead of panicking and reacting emotionally, take a step back and assess the reasons behind the loss.
Ask yourself:
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Did I put too much risk on a single trade?
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Did I execute a sufficient number of trades to dilute my risk?
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Did I deviate from my predefined trading plan and react emotionally to one loss, subsequently causing a losing streak?
Guidelines to consider:
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Don’t panic on a single trade- If you lose 5% of your account, remember that 95% remains intact.
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Ensure you have enough trades so that one single trade does not disproportionately impact your day. Some general rules are risking a maximum of 1% of your balance on any one trade, and executing a minimum of 5 trades per trading day.
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Recognize that a losing day may be an anomaly, and with a smaller amount of capital at risk the following day, you can approach the market with a clear and rational mindset.
3. Implement a Pre-Defined Daily Loss Limit
To protect yourself from the psychological impact of loss aversion, use a pre-defined guardrail on how much you are prepared to lose on any day trading. This is known as a Daily Loss limit, and the idea behind it is that it protects your account from large drawdown. For example, a daily loss limit of 5% means that even if you have a bad run of losses, your account will not be decimated. Losing streaks are much more common than you think. For example, with a win rate of 30% you can still potentially have 10 consecutive losses.
A daily loss limit helps in preserving your capital. For example, if you start with an account balance of £10,000, setting a daily loss limit of 5% would mean that even if you lose every day, you will still keep your account alive 3 times longer than if it was based on the fixed number from day one. This is because your daily balance is adjusted each trading day, taking into account any losses incurred the day before, and this dynamic loss balance enhances longevity in a trading environment.
Fixed vs. Dynamic Loss Balance
Conclusion
Managing the emotional aspects of trading is as crucial as mastering technical and fundamental analysis. Recognizing how loss aversion and other cognitive biases influence your trading decisions helps you to develop disciplined strategies that help safeguard your capital and promote consistent trading performance.
By reframing your decisions, analyzing losses objectively, and setting protective stops, you will be better equipt to navigate the psychological challenges of trading. Additionally, continue to educate yourself on any potential biases you may be facing, so you can more easily recognize and understand any biases that could potentially undermine your trading success.
Ultimately, cultivating a balanced and informed mindset will empower you to make strategic, rational choices that align with your long-term trading goals.
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