An introduction to loss aversion for traders

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.

Mind over matter - always: Shutterstock

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.

Enough of the status quo: Shutterstock

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...

You can't win every trade: Shutterstock

3 – Valuing gains and losses in different ways – Prospect Theory Bias

Or, how risk is valued. Originally this theory was mined by Israeli academics Amos Tversky and Daniel Kahneman in the 1970s.

They found that when presented with the same option in two different ways, there’s a greater chance of someone picking the option offering greater certainty. In other words, if offered £100, or the chance of £150 but a 10% chance of losing it, the £100 is generally taken.

Twist this about and look it another way – prospect theory is about low risk. If you under-respond to small probabilities, that’s still a super-risky choice.

So much depends on how probability is positioned (just ask the cash-rich insurance industry). In other words, only the final outcome matters.

Daniel Kahneman honored by President Obama: PA

Lastly...the bias that will sink your finances at breakneck speed

It's called Martingale. It’s not a loss aversion bias strictly but we include it to be a wee contrary. Martingale bias came out of the gambling dens of eighteenth century France (where it should have stayed) and is based on the premise that sooner or later your luck will change.

The problem is, you may well have run out of money by the time your luck changes. Imagine a simple 50-50 coin toss game where losses (or gains) are doubled every time. Toss the coin, lose. Toss again (and double your bet), lose. Lose again (very possibly). Etc.

This bias is heavily tilted towards random chance and the idea you will win and cover your previous positions. Eventually. But how long is a piece of string? And how many stakes can you truly afford to lose? Do the smart thing and avoid. Always. Always.

Martingale – not a good look, ever: Shutterstock