Losing, like winning, is part of life
Unfortunately some traders (and people) handle loss rather more badly than others. Their fear of it preoccupies them more than is realistic or healthy. So their neural pathways need a basic plan – a strategy that factors in losses as predictable and ordinary.
It's helpful to know what loss aversion biases there are, so they can be identified when they rear their heads. If you don’t you will struggle with trading on a basic level. You will also – warning – not be very good at it.
We’re going to look briefly at four loss aversion biases to arm yourself with some protection while you learn the cognitive basics. Be advised, your brain neurons may get a work-out while reading.
We start with loss aversion bias no 1 – Status Quo Bias
Status quo bias leaks complacency. It’s highly biased towards “going with the flow” or not being that on the ball.
While doing very little is often an excellent idea, sometimes it’s a very bad idea. Especially when events are changing fast. Given the demands on day traders to sometimes switch and re-think positions fast, this bias is especially dangerous.
- In investment-speak, Status quo bias is similar to a buy-and-hold strategy
- But the financial world has many overlapping financial fast lanes – currency gusts, commodity and economic news plus central bank moves – not to mention lighting-quick information flows
- If you’re trading you have to respond to these moves
Status quo bias is the opposite of ‘safe’. Often it’s very unsafe. So pay attention to everything and be prepared to shift your view.
Loss aversion bias 2 – Disposition Bias
This is a tendency to sell early and hang on (and hang on) to losing stocks. You could term it Wanting-My-Money-Back-itis though trading stocks has no claim on consumer rights law.
- This bias has its roots in an inability to accept our daily mistakes – or that we are simply wrong in lots of things
- Getting things wrong is normal
- Obviously you need to balance the books with getting enough things right too (and if you can’t do this then steer clear of trading)
This bias has strong links to pride and timidity. Remember that any asset’s performance has little relation to its price when you buy. You buy on the future value of a commodity, not just the entry ticket price.
This bias has links to prospect theory bias...