Editor's note: This weekend, we're taking a break from our usual fare to bring you an essay from TradeSmith CEO Keith Kaplan. In it, he details how the fear of losing money limits your portfolio's chances of turning huge profits... and how one simple tool could remove emotion from your investing decisions, ensuring you stay rational in any market environment.
Let's make a bet.
We'll flip a coin. If it comes up "heads," I'll pay you $20. But if it comes up "tails," you'll owe me $10.
The odds of the coin toss are 50-50... But the payoff potential is 2-to-1 in your favor.
Would you take that deal?
Most people would not, according to a library of academic research. This unwillingness is linked to a very simple cognitive bias.
You see, behavioral economics and psychology research show that human beings are TWICE as fearful about losing money as they are about winning money.
This bias is known as loss aversion.
It won't just make people avoid games, even if they offer favorable odds... It can and will stifle your ability to maximize returns in the stock market.
Let's dive in...
Nobel Prize-winning economist Daniel Kahneman first proposed this heads-tails game to measure human risk.
He started his research by asking students how much money he would have to risk to get them to bet $10 on a coin flip. The answer was typically higher than $20.
But here's the thing: Even at $20, you should make this bet... You should want to make it over and over again.
It might take a second to understand the math. But each flip provides a mathematical net benefit to you of $5 per flip. That $5 is the "expected economic outcome" of each coin flip.
We obtain that number by calculating the 50% odds of the $20 wager minus the 50% odds of the $10 outcome, or ($20 x 0.5) – ($10 x 0.5) = $10 – $5 = $5.
The odds are in your favor the more times you play.
Now, you might ask: "What if I lose four out of five times? Or worse, five times in a row?"
That type of conflicted thought process drives individuals to avoid risk-taking, even if the odds favor them.
Humans are ecstatic when they win... and are upset when they lose. And that fear makes them take fewer risks.
Does that sound familiar?
Think about your mood on days when your portfolio increases by 2%. You're pretty content, right? You think about how much you've made on paper.
Now think about those days where a sell-off occurs. Even if you're a long-term investor, the idea of being off 2% on paper elicits stronger emotions...
This "loss aversion" drives investors to make bad decisions around their investments and their investing strategies. This can include:
- An urge to invest in low-paying bonds, gold, or other "safe havens" like cash. These assets offer little real return and can reduce your long-term purchasing power due to inflation.
- The unwillingness to sell a stock simply because you don't want to take a loss. As a result, the stock might fall further and further, creating bigger losses and more regret. This ties into another cognitive bias (people don't believe they've lost until they sell).
- Selling stocks to avoid losses when signals suggest that you should either hold the stock or even build on it.
- Buying a stock and quickly selling it for a small gain, simply to feel the satisfaction of having a winner.
- Calling a brokerage to talk about building a 401(k) retirement plan, and ending up purchasing a high-fee, ultra-conservative annuity plan.
It's not just the stock market where we see loss aversion take hold, though...
Due to a fear of "losing" money, many people won't sell their homes at a loss, even if they need to leave town for another work opportunity. This can result in higher costs over the long run, especially if they cannot retain a tenant.
Furthermore, consider the sunk-cost fallacy. This is when you continue to invest in something because of the amount of time and resources you've put into it.
Someone might continue to shell out money to keep their beat-up clunker running when buying a new car is the better financial choice. They don't want to concede a financial loss because of the years of memories and money they've put into their car.
Loss aversion can lead you to avoid risk and build overly conservative portfolios. It can also lead you to hold on to your losers longer than you should... exacerbating your losses.
That's where a risk-management tool like trailing stops can help. Simple trailing stops are a great way to set an exit plan ahead of time, helping you stay emotionless and disciplined in volatile markets. But you can go even further...
TradeSmith provides the tools necessary to "set your portfolio and forget it."
Instead of spending countless hours jumping in and out of stocks, our risk-based volatility scores help you understand the risks associated with each stock or fund you own.
And instead of acting irrationally when your portfolio is struggling, you can churn out profits... get past the biases holding you back... and prevent significant losses in good times and in bad.
Editor's note: TradeSmith's system sent out a "Bear Market Warning" in February 2020... sounding the alarm for thousands of investors before stocks plunged 30%. But now, it's sending out a new, different alert... And it's absolutely critical to your wealth that you understand what it's telling us now. It could be the difference between escaping another crash or making extraordinary gains over the next few years. Click here to learn more.