Accept losses to become a consistent winner

One of the most common subjects discussed in the trading world is “loss aversion”. Why do sophisticated and unsophisticated traders both struggle to take their losses? In this article I move the debate a step forward (I hope) and offer a solution to this psychological challenge. I will start by sharing a recent consultation I had with Elza a prop hedge fund trader. She has very kindly given me permission to share all of her case details. Elza had been struggling to raise capital for her own fund and was struggling to set a launch date, due to a lack of funds she decided to use more leverage and take riskier positions, because she used highly leveraged instruments Elza exposed her fund to volatile capital swings. However the positions did not work out as expected, she did have an opportunity to close the positions and take a smaller lose but she didn’t. The losses increased until like everyone single one of us, she reached her psychological pain threshold and closed the positions. At this point this had little option but close the fund and transfer the remaining capital back to investors, she now has the unenviable tasks of making a living again, while at the same time trying to rebuild her reputation in the fickle financial world!

So why like Elza do so many traders have difficulty in taking a loss? A lot of research has been carried out regarding “get evenitis” and it is a psychological component that plays its part in “loss aversion”. It seems that once people make a financial commitment they become very reluctant to pull out, it doesn’t seem to matter that they become anxious and experience feelings of regret or blame themselves for making such a “stupid” decision, some take it a step further and believe they have ruined their families future, in spite of experiencing these powerful negative feelings they hang on to their investment. In fact empirical evidence shows me that many of these investors still believe their poor investment will work out in the end.  They seem hell bent of making it work, confusing passion and drive with rational, objective investing if indeed the latter exists.

Shefrin and Statman (1985) suggest that traders generally sell their winners too early and hold onto their losers for too long. I appreciate realising a loss can be psychologically painful but it doesn’t have to be this way and I will discuss the other options latter on in this blog. Jeffrey Heisler (1994) offers empirical evidence regarding the effect of “loss aversion” on futures traders. His data included details of over 2′000 individual accounts, containing over 19′000 trades, from November1989 to October 1992. His study deals with the behaviour of off floor traders in the Treasury Bond futures market. He uncovered that off floor traders hold initial paper losses longer than trades that show a paper profit. He finds that when traders hold losing trades, their activity is not profitable, they aren’t profitable traders! Not much surprise here, I think at this point it’s fair to suggest that Elza and the traders in Jeffrey Heisler’s study are acting irrationally, aren’t they? I think it’s also fair to suggest that as you read this and I write this we both understand that this is irrational behaviour and we both know it isn’t the way forward if we are serious about returning consistent profits? So what we need to do is, recreate this detached pragmatic approach when our own capital is invested.

But how do we do this?  I’m not so interested in the reason why investors refuse to take a loss, I’m however extremely interested in finding a solution to this challenge. If we appreciate that the behaviour discussed in this blog is irrational  and the actors involved know their behaviour is irrational when they review the situation, then why do they fail to take objective action and accept the loss and move on? I believe there are two reasons, the first is and this is the least important one, they are fearful the investment will reverse on a dime and move into profit, leaving them feeling “stupid and angry” they missed out. The second reason is they are unconsciousness, not unconscious laying on the floor with a bottle of vodka next to them, they are unaware of their actions they are being run by old pre-conditioned thought processes. They are focusing on how bad other past losses made them feel or they are projecting their thoughts into the future, dreaming of what they will do with their profits, this attachment to unrealised profits is dangerous and creates an anxiety gap, let’s save anxiety for another blog though.

A simple solution, next time you are faced with the dilemma of closing a losing position or taking a hit on an investment, bring your focus into the present moment and disassociate from the decision, you can do this by:

1. Bringing your attention into your body, notice your breathing and the energy inside you. This will reduce the activity in your mind.
2. Imagine standing in front of you is the complete trader you, the trader you aspire to be.
3. Notice which qualities your true trader self has, are they calm and rational under pressure?
4. Now float out of yourself and into your true trader self, soak up all the qualities, how good does it feel?
5. While as your true trader self, review the challenge regarding taking a loss and in this disassociated objective state offer advise to yourself and make the pragmatic decision.

You notice when you disassociate from your challenge, as you would do when a friend or colleague is asking you for advise, you are rational, objective and offer good unbiased advise, this is because you are consciously aware of your actions. Don’t believe what i say, try it for yourself and notice the results you get.