Trading Biases - Loss Aversion - The Biggie.

One of the most common mistakes we all make as traders is to think that we really have 'free-will'. There is a saying which is often quoted by traders - 'You pays your money, you takes your choice'. - The underlying message being that we are totally in charge of our own choices and essentially we have free-will when it comes to decision making. Having been a trader for 25 years, and now as a trading coach, I actually think that this is a dangerous illusion which derails many if not most traders. At the core of this is the belief that traders are affected by a wide range of psychological, philosophical, physiological and sociological affects which influence their ability to think and act rationally when it comes to making their trading decisions.

All people suffer from natural biases and traits. These biases and traits have evolved over millions of years, they are part of our natural make-up and have aided our survival and have helped us thrive in the natural environment. - A few thousand years of domestication versus millions of years of evolution have however not been enough for us to lose these biases and traits which are really our basic instincts. In the trading environment many of these 'basis instincts' can severely impair our ability to read the markets objectively and make good trading decisions. - The first step I implore traders to take in order to help mitigate the destructive affect of biases on their trading is to try and understand these biases, and to become fully aware of them. Below, is a description of what I believe is the main destructive bias to impact one's trading. 

LOSS AVERSION BIAS.
Over the past couple of decades the fields of behavioural economics and finance have shed a huge light on the way we as humans make our decisions in relation to financial matters. Probably the most significant advance in that time was work by Amos Tversky and Daniel Kahneman on 'Prospect Theory' for which Kahneman was awarded the Nobel Prize in Economics in 2002. One of the central elements of this was 'Loss Aversion' bias, which states that people have a psychological tendency to handle equivalent gains and losses differently; a loss almost always feels more painful or detrimental than an equivalent gain.

An example of this would be the pain that losing an amount (say $50) is worse than the equivalent joy from gaining an equivalent amount. This bias manifests itself in all sorts of ways in trading and investing. - Often when a trade starts losing money, there is a tendency for traders to hold on in the hope that the trade will recoup its losses, rather than cutting the losing trade early. In many cases the trade continues losing money, and the trader is faced with much larger losses. This is exasperated by many traders only taking a very small profit (or even cutting out flat) on the occasions the trades do come back. -- This creates a dangerously asymmetric risk/return profile. 

There has been much research into the 'Loss Aversion' bias: In one study it was found that people tend to view losses as having around 2.5 times as much negative impact as a gain of a similar magnitude. In other words a $100 loss has an equivalent impact (in negative terms) as a $250 gain (in positive terms). There is an old trading adage that traders 'should run their profits and cut their losses', often however traders tend to do the opposite, they act in a way that is psychologically comforting to them, but is actually detrimental to their performance. In my early days, quite some years ago, I was told by other traders 'that no one went broke taking a profit', if ever there was poor advice, then that was it! - I have seen far too many people go broke over the years because they took small profits and ran their losses. Though it was only occasionally that those losses would seriously deteriorate, when they did happen they would run and run, and it only has to happen once or twice to completely ruin someone.

Awareness of our tendency towards 'Loss Aversion' is a starting point, though on its own awareness is not going to help overcome the tendency. Traders have to ensure that their strategy and approach to trading is correct and able to offset this as well as many other all destructive biases. - I will talk about this in future articles, however it worth noting what successful traders tend to say around the subject of 'Loss aversion'. Veteran trader and hedge fund manager Peter Lynch is quoted as saying: 'Some stocks go up 20-30 percent and they get rid of it and they hold onto the dogs. And it's sort of like watering the weeds and cutting out the flowers. You want to let the winners run.'