This lesson delves into two closely related cognitive biases that cause traders to make irrational decisions about their open positions: loss aversion and the endowment effect.
Introduction: The Pain of Loss
Behavioral economics has shown that for most people, the psychological pain of losing a certain amount of money is roughly twice as powerful as the pleasure felt from gaining the same amount. This principle is known as loss aversion. This powerful bias, combined with the endowment effect, can lead to some of the most common and destructive trading errors.
Loss Aversion: The Fear of Realizing a Loss
Loss aversion is the tendency to prefer avoiding losses to acquiring equivalent gains. In trading, this means you will do almost anything to avoid turning a "paper loss" (an open position that is down) into a realized loss.
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How it Manifests in Trading:
- Holding Losing Trades Too Long: This is the classic symptom. A trade moves against a trader, but instead of cutting the loss at their pre-defined stop-loss, they hold on, hoping it will "come back." The fear of realizing the loss is greater than the discipline of following their plan.
- Widening Stop-Losses: A trader might move their stop-loss further away as price approaches it, turning a small, manageable loss into a much larger, more damaging one.
- Adding to a Losing Position ("Averaging Down"): Instead of cutting a loss, a trader buys more of the asset at a lower price, hoping to lower their average entry price. This is an extremely risky strategy that can lead to catastrophic losses if the trend continues against them.
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The Danger: Loss aversion is the primary reason traders violate their own risk management rules. It leads to the infamous trading adage: "Cut your winners short and let your losers run," which is the exact opposite of what a successful trader should do.
The Endowment Effect: Overvaluing What You Own
The endowment effect is the tendency for people to ascribe more value to things merely because they own them. Once you own a stock or a cryptocurrency, you subconsciously start to see it as more valuable and promising than you did before you bought it.
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How it Manifests in Trading:
- Falling in Love with a Position: A trader becomes emotionally attached to a stock they own. They overemphasize its positive qualities and ignore negative signs simply because it's "their" stock.
- Inability to Exit a Losing Trade: The endowment effect works with loss aversion to prevent a trader from exiting a losing position. They think, "This is a great company, I can't sell it for a loss now." They have mentally endowed the stock with a higher value than the market is currently assigning it.
- Reluctance to Sell a Winner: It can also cause traders to hold on to a winning position for too long, even when their take-profit criteria are met, because they have become attached to the idea of owning a "winner."
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The Danger: The endowment effect clouds objective judgment. The market does not care that you own a particular asset. Your decisions should be based on the current market reality and your trading plan, not on your emotional attachment to a position.
How to Combat Loss Aversion and the Endowment Effect
- Have a Non-Negotiable Stop-Loss: Your stop-loss must be set before you enter the trade and should be treated as sacred. It is your objective invalidation point. If it's hit, your trade idea was wrong. Exit without hesitation.
- Automate Your Exits: Use stop-loss orders with your broker. The automatic execution removes the need for you to make an emotional decision in the moment.
- Focus on a String of Trades, Not a Single Trade: Think in terms of probabilities over the next 100 trades, not the outcome of this one trade. In this framework, taking a small, planned loss is simply part of the process and nothing to be feared.
- Pre-Define Your Exit Criteria: Just as you have entry rules, have exit rules for both winning and losing trades in your trading plan. This removes the guesswork and emotional attachment.
- Mentally "Sell" and "Re-Buy" Your Position: For a position you are holding (especially a loser), ask yourself this question every day: "If I had all cash right now, would I buy this stock at its current price?" If the answer is no, why are you still holding it? This helps to break the endowment effect.
Conclusion
Loss aversion and the endowment effect are powerful psychological forces that cause traders to irrationally hold on to losing positions, leading to significant financial damage. The key to overcoming them is to shift your mindset from focusing on the outcome of any single trade to focusing on the disciplined execution of a well-defined process over many trades.
By using a trading plan with pre-defined, non-negotiable exit rules and by thinking in terms of probabilities, you can mitigate the impact of these biases and learn to cut your losses quickly, which is a hallmark of every successful trader.
In the next module, we will focus on building the habits of Discipline and Patience.