How to Avoid Falling Victim to Loss Aversion

Synopsis:

When it comes to successful trading, sometimes a trader’s own mind can be their worst enemy. Loss aversion is one of the dozens of cognitive biases that are a part of human nature and can hold traders back from maximizing market gains.

What is Loss Aversion?

Loss aversion is a psychological phenomenon that makes humans experience losses more severely than gains of equal magnitude.

On some level, people are aware of this lopsided emotional return, so we tend to place a disproportionate amount of attention on fear of losses rather than on taking full advantage of opportunities for gains.

A famous study of PGA golfers demonstrated the impact of loss aversion. The study by Chicago Booth professor Devin Pope and Wharton professor Maurice Schweitzer found PGA golfers make par putts 2% more frequently than they do birdie putts of the same distance. There’s no rational reason for this phenomenon other than golfers focus more and perform better when they are facing the possibility of losing a stroke on their score than they do when presented an opportunity to gain a stroke.

Why Loss Aversion Matters

Any successful trader knows making money in the market is not about being right 100% of the time. The key is finding an edge and taking advantage of that edge consistently.

If a trade has a 70% chance of producing a $1,000 gain and a 30% chance of producing a $1,500 loss, the trade will statistically be profitable over time. The expected value of the trade can be calculated by multiplying $1,000 times 0.7 and then subtracting $1,500 times 0.3. The result is a +$200 expected value. Therefore, if you perform that same hypothetical trade thousands of times, you will ultimately average a $200 gain per trade.

Unfortunately, fear of the potential $1,500 loss might make some traders avoid that winning trade altogether.

Tips to Manage Loss Aversion



The best piece of advice for traders looking to avoid the repercussions of loss aversion and any other cognitive bias is to simply remove emotions from your trading. Almost all trading emotions are motivated by either fear or greed, two states of mind that nearly always steer traders in the wrong direction.

Clearly define an exit strategy for each trade before you open it — and stay disciplined. You’re far less likely to make an emotional decision before you have real money on the line.

And before you sell a winning stock, rethink why you are selling. Is it because your original trading thesis has changed, or is it because you are cashing out in fear of losing your gains?

Disclosure: The author holds no positions in the securities mentioned.

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