Loss aversion: the biggest “sin” in trading

29 нояб. 2021 г.

"Losses loom larger than gains" - this expression is a good illustration for the term "Loss aversion" - a key concept in the Prospect Theory (Kahneman and Tversky, 1979). The Prospect Theory is a psychological theory that has built foundations for the modern field of Behavioral Finance. It is the work Kahneman received a Nobel prize for in 2002.

According to the Prospect Theory, the psychological pain of loss is nearly twice as intense as the pleasure of the equal size gain. People hate losses and are more prone to take risks when they try to prevent losses. But in trading, accepting small losses is an inevitable and necessary part.

Everyone knows that to be profitable in trading, you must cut losses fast and let profits grow. But in fact, traders do everything exactly vice versa over and over again. The reason is loss aversion. Traders let a losing trade live too long, hoping that it will get back to the green zone. At the same time, they close profitable positions too early, not letting the profit grow. People tend to fear losing the earned profit more than missing the opportunity to increase it. Though the abovementioned behavior may work for some particular positions, in the long run, it harshly worsens trading performance and is the surest way to ruin trading capital.

Some people may think that this staying in losing trades is just another psychological trading mistake one should work on to get over. But Prospect Theory says that the problem is much deeper than it may seem. Loss aversion is how our mind works as a result of millions of years of evolution. And it is not clear if it is even possible to change this fundamental asymmetry in the perception of losses and gains. One can say without exaggeration that loss aversion is the "biggest sin" and the ultimate reason that people are bad at trading in general. And this is the psychological bias we always have to keep in mind and account for when trading.

There are solutions how to decrease the negative impact of loss aversion. And they are well known but, as it often is, underestimating a problem leads to the same thing for the importance of its solution. The solutions are the following:

• In each trade, one should risk such an amount of money that does not trigger any pain in the case of loss,
  
• One needs to develop a system that has a statistical edge and then strictly stick to it.
  

The other helpful tools to address this problem are automation and algorithmic trading. Algorithms can make many boring small trades systematically without getting tired and not affected by emotions. And various kinds of trading automation offered by state-of-art charting software help manual traders stick to their systems (real-time alerts, trading signals visualization, dashboards, etc.).