In trading, there prevails a subliminal danger that potentially lingers in every trader’s mind, known as a cognitive bias. Among the biases, there is one that is seemingly common if you think about it, the loss aversion.
To begin with, the loss aversion in trading, also known as the Prospect Theory, clouds a trader’s rational decision-making process. Subsequently, it hinders trading from happening and, in the long run, potentially and utterly prevents trading to take place.
Reflecting upon the brief overview, the cognitive bias appears to be heavily jeopardizing a trader’s mind. In order to avoid the aversion, let us dive deeper into what it actually is.
Also Read: Trading Myths that Can Ruin your Performance
Loss Aversion: the Definition and Concept
In a simplistic manner, loss aversion translates to a trader’s tendency to prefer avoiding losses to acquiring gains. While this seems natural for traders to hate losing so much, it, on the other hand, also eradicates the possibility of winning.
The fundamental of trading always includes two possibilities, which are losing and winning, and they are most likely 50:50. It is, in other words, you either win a trade or end up to see yourself become a loser.
However, as Kahneman and Tversky pointed out, losses loom larger than corresponding gains. Studies disclosed that, psychologically, a loss is more impactful to the mind than a win, despite the amount being completely identical.
How It Occurs and Who is Prone to It
The loss aversion usually occurs when a trader just comes back from his/her recovery from the abyss of losing. That is to say, it usually lingers in the mind of those who have experienced losses.
To clarify, this might sound indifferent from the Monte Carlo Fallacy, but, in fact, it is dissimilar. In Monte Carlo Fallacy, a trader trades like the outcome is vivid, while in loss aversion, a trader avoids to trade for the outcome is vague.
In the context of trader, those who experience the bias are mostly novice traders. It is, in addition, justifiable for those who barely start to trade to suffer from ‘the mental misconception.’ Nevertheless, it is something that should be removed.
The Lingering Danger of Loss Aversion
The disaster it causes varies, but the most calamitous is totally promoting a trader to be not a trader. Yes, they may quit.
Prior to quitting, loss aversion will, in a brilliantly gradual manner, put a trader’s mind into a hesitation of to trade or not to trade. This hesitation, if turns into action, utterly scraps the possibility of winning and losing in a trade rather than helping analyze the way to win than to lose.
In short, choosing not to trade in trading simply due to the fear of losing can be the equivalent of lurking in the comfort zone. To win, one must experience losses or, at least, put one’s life in between losing and winning. No pain, no gain.
Avoiding the Cognitive Bias
Disclosed above, the bias emerges since the outcome is vague. While traders, with all their power and might, could possibly not change the outcome, they can, at the very least, predict it or adapt their way to reach a certain outcome.
To avoid bias, traders should ‘disambiguate’ their very own information. This, in addition, includes their capital to trade, their tolerance in losing, as well as their trade journal. Also, to avoid an unbearable streak, traders should also learn how and when to implement a stop loss.