The Emotions Behind Losing
Say we give you €50. You can:
A. Keep €30
B. Gamble with a 50/50 chance of keeping or losing the whole €50.
What do you do?
Now let’s try it from a different angle. You are given €50, but now you can:
A. Lose €20
B. Gamble with a 50/50 chance of keeping or losing the whole €50.
What do you do?
Most act in a risk-averse way and keep the €30 in the first question, and most act in a risk-seeking way and gamble in the second question.
The two problems above are the exact same, but worded differently. The second is framed as a loss, and doing that causes people to become risk seeking because we hate losing.
Losing €10 is a lot more painful than the joy of gaining €10
Or more accurately, we fear losing. Why is that? Well, our brain processes losses as 2.5 more painful than the gains made from winning.
We call this disproportionate value assignment loss aversion, and that fear of losing causes us to drift away from logical and rational behaviour, and instead we act emotionally and impulsively. This can cause a lot of problems in trading, where impulsive decision making can be very costly.
Impulsivity tends to drive bad trading decisions, for example:
· Cutting winners too quickly
· Letting losers run
· Increasing size in emotional attempts to win back loses quickly
In particular, losing causes us to become more risk seeking, as we’re desperate to avoid the feeling of loss again.
Let’s delve further into the behavioural science behind what happens when you lose, and then continue to lose. There are two key biases that can contribute to losing streaks:
1. Status quo bias
We don’t like change, so we tend to stick with the same decision making process or strategy we made earlier. Even when a new option or direction becomes available that is more beneficial to us, the status quo bias makes us inert and we don’t make the change.
We stay with our current insurer even though a new company offers better benefits.
We use the internet browser that is preinstalled in our laptop.
We stick with a trading strategy that has been generating consistent losses.
2. Sunk cost fallacy:
If we’ve invested resources into something, we find it difficult to cut our losses 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.
Think of the amount of times you’ve watched a film, hated it half way, but continued watching until the end
Think of all the people who got “addicted” to the Facebook game Farmville-they 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.
Think of all the time you’ve stayed in a losing trade for too long.
So how do we combat all this brain behaviour? We cannot get rid of biases-they are ingrained in our subconscious and happen automatically. We can understand them though, and create strategies that work with them.
1. Change how you frame your trading decisions.
Remember the problem at the beginning of this blog? Two different ways to frame the same question, one that activates our loss aversion and one that doesn’t.
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?” instead ask “Would I short right now?”. If the answer is yes for the latter question, it should be yes for the first question too.
2. When you do have a losing day, instead of panicking, ask yourself why.
Ask yourself if you put too much risk on one trade? Or did you get a sufficient amount of trades to dilute your risk. If you have lost 5% of your account, there is still 95% remaining.
Make sure you did enough trades (we recommend 1% risk on any one trade) so at a minimum you should have got 5 trades executed. If this day is an anomaly, then you will quit with only a 5% drawdown. You’ll have slightly smaller amount of capital to risk the next day, and you can come back to the markets with a clear head.
3. To protect from the psychological impact of loss aversion use a pre-defined guardrail on how much you are prepared to lose on any day trading.
The idea of a Daily Loss Limit is to protect your account from large drawdown. A daily loss limit of 5% means that – even if you have a really bad run your account will not be decimated. Bad runs are much more common than you think. If your win rate is 30%, every second week you’ll have 10 losers in a row.
Say you start with €10,000 and lose every day-you will keep your account alive 3 times longer if you adjust your daily balance each day.
Fixed V Dynamic Loss Balance
The above are suggestions in how to use different strategies to combat the negative impact loss aversion can have. Education is also a powerful tool- simply being aware of your biases can improve your trading habits.