We humans are hardwired to be more sensitive to potential losses than to potential gains. Our biological predisposition to loss aversion, a well-known behavioral bias, means that most of us work twice as hard to avoid the risk of a loss but put relatively little effort into seeking a reward.
As defined on Wikipedia, in economics and decision theory, “loss aversion refers to people's tendency to strongly prefer avoiding losses to acquiring gains. Some studies suggest that losses are twice as powerful, psychologically, as gains.”
Marketers often try to manipulate consumer purchasing behavior by applying the loss aversion theory to price. If you’ve ever used a coupon or mailed in a rebate, count yourself among the majority who prefer getting a discount to avoiding a surcharge.
Loss aversion and trading
Loss aversion creates an interesting problem for traders. Intuitively, we let our emotional attachment to not losing override the logic of cutting our losses short. We avoid risk in the domain of gains but seek risk in the domain of losses, so the natural inclination is to let unprofitable trades run in hopes of a reversal.
To paraphrase an example from “Thinking Fast and Slow” (Farrar, Straus and Giroux), a book by Daniel Kahneman (who is widely regarded as the father of behavioral economics), consider two scenarios:
1) You win a contest and the prize is a choice between two options — to either receive a guaranteed payout of $900, or to take a 90 percent chance of getting a $1,000 payout albeit with a 10 percent chance of getting nothing.
2) You are fined and given a choice between two options — to either pay $900 outright, or to take a 10 percent chance of paying nothing but with a 90 percent chance of having to pay $1,000.
Which of these two options above would you choose?
According to loss aversion theory, the vast majority of people will choose to receive the guaranteed $900 as outlined in scenario one and they will gamble for a chance to pay nil in scenario two. This is inconsistent (and therefore irrational) behavior: for the same $900 payout, people refuse the gamble in the domain of gains but accept it in the domain of losses.
Experienced traders are aware of loss aversion bias and they typically take steps to protect themselves against making emotional decisions. They always factor losses into their trading strategies because they know losses are inevitable. And they set ‘stop losses’ or ‘take profit’ when the market movement indicates that it’s time to exit a trade.
In contrast, traders who keep losing positions open for longer periods of time may lack discipline and they are potentially exposing themselves to ruin — especially when trading with leverage. Such a lack of risk management is more akin to a gambler’s mentality and it can make a trader more susceptible to what’s known as “Gambler’s Ruin”.
What are your thoughts on loss aversion? What methods do you deploy to help detach emotion from your forex trading strategies? Please share your remarks in the box below.