Why Traders Are Afraid to Cut Losses

As a species, humans have evolved to become risk adverse and cautious. Early humans faced an infinite number of obstacles that could lead to death- carelessness hunting, being excluded from the pack, eating a deadly plant, and so on. People who were reckless or risk takers often died before they could pass down their genes. Therefore we are the descendants of those who remained cautious and survived.

This has resulted in us fearing loss much more than we value gain. It’s the same reason most people don’t start their own businesses or become entrepreneurs. The chance of success and wealth don’t outweigh the risk of leaving a comfortable, stable job and risking your own savings.

Studies have shown that losing $100 would cause you much more pain than the happiness of winning $100. Emotionally a loss “weighs” twice that of a similar gain.This is what social scientists call “loss aversion”.

If you recall our post on the most common mistakes traders make, you’ll remember that the biggest mistake for traders is not cutting their losses. Traders tend to simply ignore losses that are unrealized. This is because an unrealized loss isn’t as painful as a realized one. So traders hold onto their positions even if the chance of recovery is small and the probability of further losses is large.

Once I was with a multimillionaire investor who became extremely upset because he has lost $100 and wouldn’t stop talking about it. I then pointed out that the value of his portfolio fluctuated by several hundred dollars every second and what a waste of emotion he was spending on a $100 loss.

Successful traders learn to eliminate emotion and get over their evolutionary fear of risk aversion. Practice this skill and you’ll have a natural advantage that most traders don’t possess.

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