It’s one of the most important charts in investing…
It shows an important idea…
As investors, we are risk-seeking when it comes to our losses, but we are risk-averse when it comes to our gains.
What does that mean?
It’s part of a concept called “prospect theory.”
Today, I’ll show you what to do about it… including a simple tool that can help you limit your losses and un-limit your gains…
Prospect theory is a cornerstone of behavioral finance and economics.
Far more important, this piece of investor psychology could save you from terrible losses… and help you get the most out of your winners.
Take a look at this chart. It shows a beginner investor’s response to gain and loss…
This chart captures what I believe to be one of the most important challenges that all investors must overcome to succeed in the markets – the tendency to prefer our losers over our winners.
What do I mean by “prefer”?
It’s all about how we respond to gains and losses in the markets. The vertical axis above measures what economists or academics would describe as of “value” or “utility.”
I like to think of it as the emotional impact of our gains and our losses.
As our gains get bigger, the emotional impact of those gains tapers off. If we get a 100% gain, that’s fantastic. If we get a 200% gain, you know it’s twice as great… But, emotionally, it doesn’t feel twice as great as a 100% gain.
On the other hand, as our losses increase, the impact of those losses doesn’t taper off in the same way that the impact of the gains tapers off.
If you take a 25% loss, that hurts. But if you take a 50% loss, it hurts a whole lot more. You take a 75% loss, and it’s really a killer.
As losses grow, they consume us. We get attached to those losing positions… We can’t let go of them. Maybe we even double down on our losses and try to get back to “breakeven” quicker. Right?
I can’t tell you how many times I’ve heard people say, “I’ll get out when it gets back to breakeven.”
If you ever hear yourself say this, get out now.
Many investors, after getting burned a few times, realize that taking big losses is a bad idea. Not only is it tough on your portfolio, but it’s tough on you psychologically. It beats you up and discourages you from taking advantage of future opportunities.
That’s why many more experienced investors know that you’ve got to cut your losers…
If we refer back to our original chart, we might say that this type of investor can get his behavior chart to look like this:
This “intermediate” level investor knows how to stop the bleeding. If you set a simple stop loss and stick to it, you’ll never fall into the trap of hanging on to your losers too long… while your suffering and mental anguish gets worse and worse.
Few investors, however, ever master the art of staying in their winners…
Financial markets regularly go places that no one expects them to go. As the economist John Maynard Keynes once said, “Markets can remain irrational longer than you can remain solvent.”
This certainly applies to losses. But markets can also lead to “irrational” gains.
Stocks don’t simply reach a preset “limit” where they’re determined to fall. They can keep rising much longer than you expect.
The key to life–changing gains in the stock market is to make that market madness work for you instead of against you – turning our original chart on its head so that it looks like this:
A stop loss is the simplest way to cut your losers and keep them small. But you have to learn to “prefer” your winners… That’s the biggest secret to your investing success.
Regards,
Dr. Richard Smith
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Source: Daily Wealth