Hello everyone and welcome back to part four of our four-part series on Loss Chasing. Pat yourselves on the back, because you’ve made it.
If you missed the first three parts of our series, you can find them here. As a brief summary, here is what we talked about:
Part one: What is loss chasing and why do people do it? In part two, we looked at a visual graphic and some statistics of our investor friend, Bob’s trading performance (Spoiler alert, it’s not good).
In the last part of our series, we delved into the science behind loss chasing, the neurobiological factors behind the chase, and the impacts, both emotional and financial.
Now that we’ve reached the end, we’re going to tie our series up into a neat little bow by presenting to you some practical strategies and techniques to help traders avoid falling into the trap of loss chasing.
We’ll discuss the importance of setting realistic goals, how to stick to risk management principles, and how to maintain emotional discipline. Finally, we’ve got a quiz for you to help you retain all the tips and tricks we’ve talked about along the way.
But first, are there any alternatives to loss chasing? Let’s begin.
What Are The Alternatives to Loss Chasing?
Despite the irresistible urge to reduce the discomfort of losses by reducing the Average Cost Basis (ACB), investors have options beyond reacting repeatedly and being slaves to their biases. The key is to break the cycle and build strategies for disciplined trading by harnessing the brain’s “executive functions”.
It is certainly difficult to think clearly, logically, and linearly during highly emotional moments, so prior to doing anything tradewise, please take a moment and exhale slowly and inhale even slower. Do this a few times.
Knowing your options in advance helps cultivate and facilitate emotional discipline in investing. From a decision perspective, instead of doubling down on losing positions, an investor can do any of the following specific actions:
- Do nothing
- Sell the losing positions and hold cash
- Sell losing positions and buy more promising investments
- Buy more of the losing asset
- Some combination of the above
Let’s go through these options:
The “do nothing” option is difficult for many people (and discouraged by Lee Freeman-Shore in his book, The Art of Execution).
This is largely because an investor has to recognize, refrain, and resolve not to act on the impulse to reduce their discomfort with the convenient click of the mouse before them. This is particularly difficult if the losses are large, unexpected, and/or surprising.
Selling the losing position is seemingly distasteful for most people because of the anticipated pain and admitting defeat. However, people often report relief afterwards largely because “affective forecasting” (the anticipated emotion following an event) is often incorrect (Kermer et al. 2006).
In my experience, and with coaching others, it becomes easier to exit a position by focusing on the fact that 1.) the remaining capital has an opportunity cost of remaining in the losing investment and 2.) redeploying the money can have a positive investment impact with 3.) a pleasant affective impact instead of the predicted negative reaction.
This has proven to be one of the most useful behavioral strategies for me. I can sell losing assets much more readily because I can now, correctly, forecast the relief I’ll feel afterwards and the regrouping and debriefing I’ll do to learn from the loss, however small.
Our second option, going to cash, allows the trader to buy some time. Especially if the trader has a strong action bias. Highlighting that the book value of the asset can be more profitably redeployed to more promising investments can ease the pain of a loss.
This often triggers “gambling on losses”, which can lead to taking an even greater risk but in a different risky asset. This is why cold, calm calculation is crucial when managing losing positions.
Option C, buying more of the losing position should be done solely for objective reasons, never in order to deal with an emotional reaction to losses.
I repeat: allowing anger, frustration, regret, or other strong emotions to be expressed through your trading platform is likely to only generate more negative emotions because the outcomes are likely to be net negative.
However, if there is a strong economic, technical, and/or other external reason for buying more then go ahead and take advantage of what might be a temporary inefficiency with an upside.
Here’s an example from my own experience: One of my most profitable purchases was of an innovative biotech that experienced a dramatic price drawdown caused by an FDA “intervention” from a notoriously bad actor (who served jail time for a different violation, take a wild guess who this might be).
My initial investment was down far below any reasonable threshold (let’s say more than 50%), but when the price dipped below the cash the firm had on hand and their sales growth was positive and accelerating, I decided to abnegate from acting on my disgust and frustration through selling and do the opposite of what my emotions were telling me to do and I bought instead.
The final option is to think in continuous terms rather than all in or all out. Having a more nuanced view allows traders to make small movements to break the black-and-white style thinking patterns that govern their behavior.
This is also discussed in Lee Freeman-Shor’s book The Art of Execution where he characterizes Assassins as those who ruthlessly kill losing positions whereas Rabbits mismanage their losing positions.
He suggests that investors have a clear threshold of tolerance to which they pre-commit to selling positions when/if they hit a loss percent. He suggests 20 to 33%, but you need to decide on what makes sense for you given your time horizon, investment approach, and personal sensitivity to volatility.
Mr. Freeman-Shor suggests either adding to the losing position or selling it entirely. The ability to determine and ascertain which asset to dump and which to double down on is the key skill that differentiates loss chasers from dip buyers.
How Does This Apply To Me As An Investor, Advisor, Portfolio Manager, Or Fund Manager?
Loss chasing is one of many behavioral biases that some investors display, yet is also one of the least known. So, if you actively manage investments it would help you to know whether you display this pattern.
Regardless of the outcome, all investors need to adopt at least a basic behavioral risk management strategy with clear pre-commitments and rule-based actions for various contingencies.
As we learned earlier, relying on our context-sensitive biological systems to guide us in difficult situations without a strong system in place is worse than leaving things to chance–it nearly guarantees we’ll make a mistake relative to the optimal, rational choice.
For clients who have had their data analyzed to show their loss-chasing patterns, and want to know if they are improving, I look for two specific types of evidence in client data:
- A clear reversal in their invisible portfolio for loss chasers or accelerated increase performance for dip buyers, and
- A negative trend in their invisible portfolio (learn more as discussed in this article).
If you’re making investing decisions, choosing what to do first requires knowing your own track record with this particular behavior., This can be done through an Investor Optimization Report containing a similar analysis to this case study, but conducted on your own data.
When you’re buying or selling assets, get clarity about your motivations and beliefs as this can dramatically improve your ability to earn higher returns. Additionally, evaluating the accuracy of gut feeling with external data can help reduce impulsive decision-making that leads to losses.
If you are a manager of other people who make decisions, such as a team of RIAs or fund managers, you can get their performance analyzed as well.
Behavioral Risk Management for Trading
After all we talked about above, it’s important to note that a trader cannot limit the scope of risk management to external data sources only, such as a standard Value at Risk (VaR) methodology.
The more active the management, the more internal risk is generated by the traders themselves and this holds for equities, forex, futures, commodities, crypto and other liquid and illiquid assets. To our detriment, the least discussed area of risk management in trading is the management of the trader’s emotions, cognitive biases, and raw human reactivity.
Together, we find that it is difficult for investors to withstand losses and that the automatic reactions lead to predictable and generally negative outcomes.
The solution is to slow down our thinking, accept and observe internal reactions, and regain the ability to entertain various options instead of being governed by our emotions.
Why Do Biases Persist?
The reason why most “behavioral interventions” don’t work is that they fail to consider decision makers’ workflow, cognitive style, and institutional and personal incentives.
This is why most make recommendations that are out of sync with how decisions are actually made and many people who seek professional guidance in trading are disappointed.
SmartTrade was created to help humans like you and me make better investment decisions across all market conditions, but are optimized to be most effective at the toughest moment in particular.
The “hot” moments when we feel compelled to act are when we need workflow guidance to allow us to overcome the inner tug of emotion and eons-old neural reactions to discomfort that do not work in our current, complex digital workflows.
My vision for this cognitive technology is to have as many people as possible benefit from it, which is why you’re invited to open an account as an early adopter of Prof of Wall Street Innovation by reaching out to me.
My hope is that you use it to better discipline your actions by letting it cool you in the heat of the moment instead of getting burned by your own emotional trades.
This completes our four-part series on loss chasing, I hope you enjoyed learning and feel more empowered to make profitable investment decisions for yourself or your clients.
If you have any questions about loss chasing or want to see how to improve your investing performance, you can schedule time with me here. In the meantime, I invite you to take the quiz below and see how you do.
Amos Nadler, Ph.D.
Prof of Wall Street
Loss Chasing Quiz
Is loss chasing a behavior unique to investing?
- Loss chasing is unique to equities investing
- Loss chasing isn’t unique to equities investing but occurs only in relation to financial assets
- Loss chasing is driven by a general neuropsychological network and it manifests across various areas of life
- Loss chasing occurs only among pathological gamblers
In this case study, this investor’s buying of losing assets:
- Improved their portfolio performance through taking advantage of price dips and selling those assets when the prices rose
- Reduced their portfolio performance through buying of assets in losing positions that continued to drop in value
- Improved their portfolio performance by reallocating capital from losing positions to better investment opportunities
- Reduced portfolio performance by failing to buy more of losing assets before their price rebounded
- Loss chasing had no meaningful impact on the overall portfolio performance
When in a losing position, what is the best way to decide what to do?
- Buy more indiscriminately, prices always rebound
- Identify and weigh my options for each position objectively and allocate capital based on the expected value of the decision instead of solely following emotions
- Allow my emotions, gut, and impulses guide my trading decisions because, as the saying goes, “go with your gut”
- Identify, acknowledge, and accept the emotions that arise from being in a loss position
Approximately what % of total traded volume was buying assets in a losing position?