Your emotions play a critical role as they attempt to alter your trading mindset. One of the hardest parts of becoming a successful trader to keep your emotions in check. Human beings are not machines and therefore handling risk and potentially losing money can generate chaos and alter your strategy. One of the keys to successful trading is handling the ups and downs of market movements. To acquire a winning mindset that will not be altered by swings in price action, you need to learn how to handle your emotions. You want to make sure that you understand the noise of the market, which can help you avoid making split decisions that can alter your trading plan. Your goal is to control both fear and greed, which will allow you to stick to a trading plan that can be successful over time.
How to Manage Loss Aversion?
Loss aversion happens to all traders at one point or another. You might experience a losing streak or face a loss on your first trade and before you know it, you are scared to place a trade. To manage loss aversion correctly you need to treat trading as a business and understand that losses are a part of your business plan. This means you need to have a good handle on trading psychology and what is needed to properly tackle the capital markets.
What is Loss Aversion?
Loss aversion is a psychological theory. It says that people hate losses more than they love gains. For the same amount of loss, say $100, many investors would rather avoid the loss rather than accept the same amount of gain. This principle is used heavily in economics. Loss aversion is different from risk aversion. Loss aversion is based on previous experiences. Some economic theories say that people hate losses twice as much as the like gains. This theory initially was used in consumer behavior before focusing on investment behavior. In traditional economic theory loss aversion comes with the endowment effect which is an irrational behavior that is considered in marketing to consumers. For example, consumers are much more in tune with price increases than price decreases. You are much more likely to stop purchasing a product if the price increases than purchasing more of the product when the price declines. The endowment effect shows that people are twice as likely to stop purchasing a product like gasoline when the price increases as opposed to purchasing more gasoline when the price drops. Loss aversion is generally followed by loss attention. This theory refers to the tendency of consumers to allocate more attention to a situation when it involves losses than when it does not involve losses. This means that you will pay much more attention to a price increase that will generate a contraction in your wealth compared to a price decrease which will cause an increase in your wealth.
Loss Aversion in Trading
The theory of loss aversion as it pertains to investment theory says that traders are more likely to becomer apprehensive following a loss than they are to become aggressive when they experience gains. This tells investors that a $100 loss is more important than a $100 gain. Since this is part of the psychological makeup of most human beings, there is a need for a re-training of your brain to understand that the two are equal. It also means that traders will pay more attention to losing positions or prior losses than they will pay to winning positions or prior winners.
How Does Loss Aversion Occur?
Since most people are hard-wired to attempt to avoid losses more than to accept gains, loss aversion happens naturally. Of course, you need to experience a loss of some sort to understand the feeling of losing money. Most novice investors have only experienced gains of some sort. For example, when you start to work, you only experience getting paid. Your employer might pay you a fixed fee or an hourly rate, but you only experience making money. Very few go to work of and if they do a poor job on a specific day they don’t get paid or even worse owe their employer money. Since losing money is not a concept that is ingrained in your behavior, your first investing experience might be the first time you experience a loss. Since you know how hard it is and how much time you had to work to make money, the fear associated with losing money on a trade far outways the concept of generating income. Loss aversion can come on for several reasons. You could be a novice trader and not expect losses. You could experience a larger loss than you anticipated. You could go through a losing streak that you did not forecast.
How Do You Handle the Fear of Losses
The first step in handling loss aversion is to understand and accept that losses are part of your investing plan. You need to expect losses and treat them exactly like gains. Loses will make up a specific percentage of your trading. You need to spend more time and attention to your losses if they make up a greater percentage than you anticipate or your losses are larger than you expect. The next step is to create a concrete trading plan. If your trading strategy is discretionary, you should have a fixed risk management plan, where you have a solid risk-reward profile. You should never place a trade without thinking about exactly how much you plan to risk on each trade and what your potential loss could be. If you trade by gut feel and don’t have a risk management plan in place, you are setting yourself up for loss aversion. Experience is the best way to overcome loss aversion. If you see that you are quick to take losses to avoid large losses or take profit quickly to avoid any type of loss, you need to take a step back and examine your trading plan and your investment psyche.
Summary Loss aversion if the fear of losing which more than offsets the joy of winning. It can be brought on by a losing streak but it is part of most traders’ psyche. To manage loss aversion correctly you need to treat trading as a business and understand that losses are part of your business plan. This means you need to have a good handle on trading psychology and what is needed to properly tackle the capital markets.