Saturday, March 08, 2008

Loss Aversion vs Risk Aversion

As almost every trader knows, cutting losses is a critically important component of successful trading. The key, of course, is to know how and when to cut those losses. Unfortunately, all too often, emotions play a significant role in when we cut our losses. Taking the loss is a decidedly unpleasant experience because it implies that we are admitting a mistake and most of us aren't crazy about admitting that we made a mistake.

I believe it is a useful exercise to keep track of how long we remain in losing trades and compare that to how long we are in the winning trades. My guess is that many less successful traders tend to remain in the losing trades longer than in the winning trades. A number of factors may influence that tendency. Among them are the unwillingness to admit we were wrong and the "hope" that "it'll come back." When I review my own trading at times when I think I am not doing as well as I should, I find that I may have stayed longer in the losers than in the winners and that is even with careful awareness of the need for absolute discipline. Once I identify the problem, I am usually able to correct it by returning to faithful adherence to my personal business plan and assuring that I adhere to my disciplined and pre-determined exits when positions go against me.

Dr. Ari Kiev, in his 1998 book, "Trading to Win" notes another even more insidious characteristic of hanging onto losers. "...[M]any traders," Dr. Kiev says, "believe, at least unconsciously, that loss is less painful when there is an addition to a larger loss than when it is a freestanding loss." In other words, traders tend to let the loss compound once the initial loss is in place. We really do need to pay attention to our losers and do something about them.

All of that deals with some of the psychological aspects of how traders may tend to deal with risk of loss and actual losses once a trade is in place. Those phenomena are distinctly different, in my view, from risk aversion. I devote much of my book, "Trade Your Way to Wealth," to risk aversion which I consider to be ways to set up trades even before we enter them to limit losses substantially or even remove the risk of loss in certain strategies. I believe that if we train ourselves to enter trades with both the knowledge of the specific risks and a method in place to limit those risks we are giving ourselves an edge in the market overall and in the control of our own trading psyches. In "Trade Your Way to Wealth," I discuss the specific risks attendant to at least 15 different strategies and show where and how those risks can be limited or, in some cases, even avoided.

Risk aversion, in my view, is different from loss aversion. In the former, we can plan our trades to avoid, limit, or at least measure the risk before we ever enter a position; in the latter case we leave ourselves in a position of trying to avert loss only after it has begun to occur. Whenever possible, I believe it is better to set up all parameters of our trades before we ever enter a position. If we do that, we have gone a long way to avoiding emotional reaction to market movement and emotional reaction in the markets is a serious enemy. If we are making our decisions in the heat of market movement, emotions will almost certainly have a detrimental effect on our trading.

by Bill Kraft, Editor
Copyright 2008, Makin' Hay, Inc.
All Rights Reserved

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