Is Loss Aversion Affecting How You Trade?

Afraid To Roll The Dice?
Afraid To Roll The Dice?

There is a fascinating phenomenon in the field of human psychology known as “loss aversion.” Loss aversion is in part exactly what it sounds like. It is the tendency which we all have to avoid loss—but it is a little more complex than that. When we experience loss aversion, we are willing to trade a chance at substantial gains for a chance to simply avoid a loss.

Loss aversion is probably impacting the way that you trade binary options right now. I will talk about that in just a bit, but let’s first delve a little deeper into exploring the concept itself.

 

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What is Loss Aversion?

Basically, psychologists have found that losses have a significantly more powerful impact on our psyches than gains (some estimate that the effect could even be twice as powerful). This information is used every day by economists, merchants, and marketers who need to find the most compelling way to frame a deal.

You may recognize some examples of loss aversion in your own life:

Think about a time in your life you were offered a small raise—say $50 a month. You probably were quite happy, but not necessarily ecstatic, right? Now think of a time your pay was cut by $50 a month. There is a good chance you were flat-out furious.

Think about a time your insurance company decided to cut you a break on your rates, putting $5 a month back your pocket. Nice, but not amazing, right? But then consider a time your insurance company decided to raise your rates by $5 a month. Even though it is a fairly nominal amount, you probably were very unhappy. You might even have picked up the phone and called to complain.

Basically, gaining something is awesome, but losing it is arguably worse.

Marketers make use of this information by carefully phrasing their adverts in terms of losses avoided.

So instead of saying, “Buy our product and save X dollars a month,” a company might say, “Don’t throw away X dollars a month; buy our product and save!”

We see this in the world of sports as well. In one particularly well-known study, researchers Maurice Schweitzer and Devin Pope looked at more than 2,500,000 putts from the 2004-2009 PGA Tour. They were looking to see what percentage of golfers successfully completed birdie putts vs. putts for par.

In case you are not a golfer, a “birdie” is simply completing a hole a single stroke under par. A birdie is better than par.

The findings of the study were quite striking. The researchers found out that only 28.3% of birdie putts were successfully completed versus 82.9% of putts for par. The implication is the golfers regularly and purposefully avoid birdie putts, leaving the question of why.

The researchers concluded that the reason had to deal with loss aversion. The golfers were so desperate to avoid a bogey (which is the word for taking one more stroke that expected to complete a hole) that they were willing to forfeit the chance for a birdie altogether.

This is a perfect illustration of how loss aversion to persuade you away from opportunities that you have to scale for. At this brings me back to talking about trading binary options.

How Loss Aversion Impacts Trading

Loss aversion isn’t necessarily a good or bad thing on its own; the real question is whether it causes you to make good or bad trading decisions. Really, this all comes down to how risk-averse you are.

One interesting example involves win percentage and the sizes of your losses and wins. A lot of traders argue about which statistic is the most important one. There is a common mindset that your win percentage is the ultimate measurement of whether or not you have a successful or reliable trading system. The higher the win percentage, the better.

But this is not necessarily true. Loss aversion causes us to want to minimize the number of losses that we experience, because every single one of them is painful, whether large or small.

There are situations where a trader with a system that wins 60% of the time actually is outperforming a trader with the system that wins 80% of the time. If the trader who experiences more losses is netting substantially smaller losses and substantially larger wins, that trader may actually have the more profitable system.

You can see how loss aversion might cause you to overlook the system with the 60% win percentage. Sixty percent just does not seem as psychologically comfortable as 80%. The thought of experiencing losses 40% of the time may simply be too daunting for a lot of traders to consider. Nonetheless, it may still be the superior approach objectively speaking.

On the other hand, to some degree, loss aversion plays to your advantage. We have all heard that, “a penny saved is a penny earned.” That is very true when it comes to trading. Every time you lose money, you have to go to the trouble to win it back before you can start stacking up a profit on top of that. So to some extent, you do want to trade as conservatively as you can without robbing yourself of too much opportunity.

When Loss Aversion Stops Trading Altogether

The most dangerous aspect of loss aversion when it comes to trading however arguably has nothing to do with trading systems or money management. It has to do with over-arching psychology.

The more time you spend on forums in the trading community, the more you come to realize that most people who dream about trading for a living will never actually move permanently beyond the dreaming stage. There are a lot of different factors at play from one person to the next, but loss aversion is definitely a common culprit.

If you fantasize about moving out of your day job and into a world where you are free to control your destiny through trading, you are putting a lot of emotional eggs in one basket. All of your hopes and dreams are in there, but all of your fears are there too. That is especially true if trading is the only avenue you see to secure your freedom.

The thought of gaining that life holds a lot of value, but the possibility of losing it is arguably more terrifying than never actually making it a reality at all. So long as you have the dream of trading for a living, you always have that sense of possibility. If you try and you fail, then you end up losing everything, even your hope.

I have seen this stop countless traders from ever actually making it. They are either too scared to try in the first place, or they do try and up losing money, and are so crushed by that loss that they will give up on a second chance simply to avoid repeating that loss.

So you can see how loss aversion is a very powerful thing. You may have even experienced something like this before. In a way, it is like going on tilt. But instead of your loss of emotional control causing recklessness, it causes you to take such absurdly conservative approach that you actually end up frozen.

If you are in a predicament like this, really the only thing that you can do is change your viewpoint. You have to put your emotions into a different perspective. You have to learn to start assigning more significance to your positive emotions, even though you may feel them less intensely than your negative emotions. You have to learn to put as much value on the possibility of victory as you do on the possibility of defeat. This is not an easy thing to do, but it may be a necessary perspective shift if you really want to change your life.

We all sometimes go through life with the attitude, “What you never know can’t hurt you.” The trick to changing your perspective is to figure out that what you never know can hurt you. If excessive loss aversion is causing you to rob yourself of the potential for a better future, you are hurting yourself, even if you do not see the shape your life could take if you took a different approach.

So if you have been holding yourself back from embarking on a trading career for fear of the losses you might incur, financial and otherwise, it is time to re-examine your perspective and put loss aversion in its place. You should never throw yourself heedlessly into pointless risks, but you cannot go through life without taking risk. You will achieve the most with a balanced approach!

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