Misconceptions of Taking Losses

"It's not about being right or wrong, rather, it's about how much money you make when you're right and how much you don't lose when you're wrong". - George Soros

What the Khaneman/Tversky experiment revealed is that, contrary to the common assumption, it is not risk that people abhor, but rather it is taking losses. Moreover, the fear of taking a loss appears to overcome the ability to think rationally. Why were 92% of the respondents in Scenario 2 willing to make a terrible bet? It appears they were focused only on the likelihood of a negative outcome and willing to do anything to avoid it, even something foolish.

As a trader, you will find yourself faced with this challenge every time you make a trade. In fact, the practical effect of Prospect Theory is that traders sell their winners too early, satisfying the desire to be right, and hold their losers too long, hoping that they will not have to take a loss and be proven wrong.

Consider the following real-world examples: 

1. You are long at 25 and the market is trading at 20, which is a major support level. If the market trades below 20 will you get out with a loss or will you hold on, hoping the market rallies back?  Will you search for another support point at, say, 10 and buy there to improve your average position price?

2. You are long at 25. The market rallies through resistance at 35, trades up to 75, and breaks back to 50. Do you take a profit at 50, aggravated that you have “lost” 25 points, even though the market is trading well above the new support at 35? 

In both these cases and countless others similar to them, traders make the wrong decisions far too often. If you have convinced yourself that realizing a loss constitutes failure or that you must grab a profit because a sure thing will always be better than the uncertain future, you have passed into the realm of irrational thinking.