Super Gann Trader Academy which conducts share market training in Mumbai, offers free trader awareness lessons.
Loss aversion is a phenomenon in our thinking that causes us to prefer to avoid losses more than preferring gains. We hate losing more than winning the same amount. Our loss aversion goes up as stakes rise higher.
Examples of loss aversion bias include:
• In sports, teams change tactics from aggressive to defensive play when they are ahead in the game. Instead of increasing their lead they try to hold on to their lead by playing defensively.
• Marketers market products using loss aversion themes “Don’t lose $100 for energy expenses every year! Buy our new product furnace gizmo!”
• People continue to stay in bad relationships or jobs as they fear losing what they have.
• Investors hold on losers for much longer to avoid experiencing the pain of losing when selling stock at a loss.
• Investors also sell their winners early because they fear that the gains may be lost when market price fluctuates.
By doing this investors/traders violate fundamental law profitable trading. “Cut your losses early and ride your profits”.
Let’s play a coin toss game. The probability of winning is 50%.
Heads, you win Rs 10000/-
Tails, you lose Rs 8000/-
This coin toss is a favorable game to play. However most people turn it down and do not take the bet.
The payoff needs to be at least twice the loss amount for most people to take the bet. This is because the pain of losing is much higher than the pleasure of winning the equivalent amount.
How does this affect us?
If we look at a bet like this as a single bet every time, we will not take the bet. This is narrow framing.
However, we can think differently and broaden our horizon.
Suppose if we decide to play this coin toss game for 100 times instead of once. The result will be a gain of Rs 1 Lac. The chance of losing from this game will be close to zero.
Income-50 Heads x 10000=500,000/-
Expense- 50 Tails x 8000= 400,000/-
Instead of viewing each risk situation separately, we can view it as part of a big game. Such broad framing allows us to play this highly profitable game.
Investors and traders can invest/trade by taking low risk per investment exposure in the market when probability of success is in their favor. They can play this game indefinitely by using smart money management strategy and make a fortune over their life time.
Trading systems help us to identify low risk favorable opportunities in the market.
Here the List of Blogs in this Series
- Can Confirmation bias cause us to make mistakes in share market?
- Can seeing patterns be cause of losses?
- Why do we need rules in trading?
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