There are some interesting facts about people when it comes to evaluating risk and loss.
If we take a look at our perception of risk for example we’ll find that most people think that something familiar is much less risky than it actually is. While at the same time they think that something unfamiliar is much more risky than it actually is. Let’s take a look at some perceptions and compare them to reality.
I’d venture to guess that most people are afraid of skydiving. If you went skydiving an average of once a year over your lifetime, your odds of dying while doing that activity are about 1/100,000. In contrast, the odds of a frequent flier dying in a plane crash over his lifetime are about 1/20,000 making a case that jumping out of the plane may be less risky than the plane ride itself.
How about this one, do you have a bathtub in your house? Well if you’re afraid of skydiving or airplanes, you should be terrified with your bathtub because you have a 1/11,000 chance of dying there.
How about your car? You have I 1/100 chance of dying in a car accident over your lifetime and yet many of the same people who won’t even get into an airplane think nothing of getting into the death machine known as a car and not even pay attention while driving. The point is that we have an amazingly warped perception of risk.
If we take a look at aversion to loss it gets even more interesting. We find overwhelmingly that most people would rather give up the possibility of a reward than face the prospect of a loss of similar magnitude. In other words, people will do a lot more to avoid losing $10,000 than they will to get $10,000. When in reality if you spend more time working for that $10,000 and less time protecting it, you’ll be a lot better off because just like a sports team, no matter how good you are at defense, you’ll never win the game if you don’t make a goal.
Let’s take a look at how these tendencies affect your trading. Many times when I’m working with a struggling trader, the reason they’re struggling is due to improperly perceiving risk combined with an unwillingness to let a position draw down.
A point to remember is that in order to make progress in any area of life there is risk. And the more risk you’re willing to take, assuming it is calculated risk, the farther you can go. If you want to walk, you risk falling down. If you want a relationship, you risk a broken heart. If you cross the street, you risk getting hit by a car. And if you want to make money in the stock market, you risk losing money and damaging your ego. That’s just the way it is.
Many times I see people trying to trade without taking any significant risk at all. They say things like “What if this happens or what if that happens?” They’ll have so many puts on or their T+0 lines will be so flat that they can’t make any money and often destroy an otherwise great trade, trying not to lose it. At the very least they’re giving up a lot of profit every month. They are literally losing by trying not to lose.
The simple fact is that you MUST allow a position to draw down a reasonable amount and you must be willing to take a reasonable loss on your trades in order to win long term. Considering this, it’s imperative that you properly evaluate risk and change your perception of losses so that you can trade with a winner’s mindset.
One trick I play on myself in order to eliminate my natural tendency to overprotect against losses and to make better decisions is to look at a trade as an investment. For example if I have a trade with a $10,000 maximum loss, then before I enter the trade, I do two things. First, I evaluate the trade to see if it is worth spending $10,000 on, because that’s what I’m actually doing. Second, I mentally take that $10,000 out of my account and consider it GONE. I then consider anything I get back out of that 10,000 a return on my investment.
This is a lot different that randomly entering a trade and hoping I’ll make money. It forces me to want to evaluate the trade very closely prior to entering. After all I’m spending $10,000 on it. It also makes me aware of what it feels like to no longer have that 10,000 which has the added benefit of letting me know I can afford the trade or if I’m trading too large. And most importantly it allows me to “trade to win” because the 10,000 is already gone and I no longer have that “resistance to losing” making it much easier to “play to win” and achieve my goal of doubling my investment rather than treading water trying “not to lose”.
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