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The Sunk Cost Fallacy

Have you ever held onto a trade that was going against you, but instead of closing it out for a loss—your stubbornness and disbelief kept you in it longer leading to further losses and deeper psychological wounds?

Who wants to trade with knots in their stomach and deal with unbearing stress?

I know I don’t.

Have you ever heard of something known as “loss aversion” — which is related to “the sunk cost fallacy”.

This is one of the most important concepts to learn as a trader.

Why?

Losses are a part of the game… and Daniel Kahneman and Amos Tversky — two important researchers in the decision-making field — came up with a principle that “losses loom larger than gains”.

Psychologically, the pain of losing is about two times as powerful as the pleasure of gaining.

What’s that mean for traders?

It’s a lot harder for us to take the L and move on.

And do you know what else is interesting?

Those same traders who have a hard time letting go of losers—are the same ones who are too eager to take profits—never giving themselves the chance to let the trades run for more substantial gains.  

But riddle me this: Does it make sense to hold onto your losers and not your winners?

When you say it out loud… it clearly doesn’t.

Remember, stocks can stay irrational longer than we can stay solvent.

So how do we avoid this “loss aversion” mentality and not get trapped by “the sunk cost fallacy”?

The Sunk Cost Fallacy could be hurting you more than you think…

So on Friday, I spotted one of my favorite patterns in Synthesis Energy Systems Inc. (SES)… and I even let my clients know about it…

I was watching the stock closely… but I felt that paying $3.60 at the time was too risky… because the stock already had a monster move.

My trade idea goal was $5… which the stock easily hit earlier in the week… then it went to $10, $15, and $20… even $25.

I thought to myself, “If I had just bought my normal position size of 10,000 shares… I could’ve made $220,000 in gains a day later!”

Then I thought again, “No way I’d have held for $220K gains… I would’ve taken $10,000 in just a few hours instead.”

So what’s this all got to do with loss aversion and the sunk cost fallacy?

Well, I’ve traded small-cap stocks long enough to know that once a stock pops… there are traders looking to bet against it. I’m sure when SES was trading around $3.60… some traders shorted SES and hit -$22 per share.

That’s what I want to talk to you about today.

It’s really hard for us to let winners ride… but it’s so much easier to let losses get out of control.

So what’s the sunk cost fallacy?

Well, think about it like pouring money into something that’s not working for you. Basically, in trading terms, it means you’ve spent so much money buying a stock… and when it goes against you… it’s so difficult to take the loss…

… instead, you might do things that make you worse off — you might move your stop… dollar cost average… take on too must risk in relation to your account size.

Getting back to the SES trade.

When I alerted SES, let’s say one of my clients bought at $3.60… and the person on the other side could be short the stock (betting against the stock).

The buyer makes money if it goes up… the short seller makes money if it goes down.

This is where “loss aversion” comes into play (for the short seller)

It’s human nature to let losers run — to avoid taking a loss… but cut winners short to avoid losing a small gain. 

 

This is something I’ve struggled with before… but as I mature as a trader — I’m starting to learn more about “loss aversion”.

The bottom line is that some of my biggest losses over the years have come from short-selling big day first movers in small-cap momentum stocks.

It seems logical at first… but the lesson here is that buying 10,000 shares of a $3.60 stock means you’re on the hook for just that. But if you short the same amount and the stock rockets higher… you could have been sitting on $220K in losses.

So how do you avoid the “loss aversion” mentality?

It’s simple.

You write down your trading plan and clear-cut rules.

For example, if you wanted to short SES at $3.60… you have to think, what’s the worst-case scenario first. The stock could double or more. So then comes the question, how much are you willing to risk.

Let’s say the maximum you’re willing to risk is $1,000 on the trade. You would probably try to trade 500 to 1,000 shares at most. That way, if the stock gaps up $1 (over 25%), you would still be okay, and just slightly over you’re risk limit.

Now, if you are willing to risk more and actually plan on dollar-cost averaging, make sure it’s writing down at exactly what prices you want to short more shares… as well as your stop loss.

Respect your plan and your stop losses… and you should be able to prevent loss aversion.

Loss aversion is a real thing… and if it’s something you’ve come across and not addressed… it could lead to severe damages to your trading account.

The thing is… don’t look at losses as failures… look at them as learning experiences because it’s better to take a small loss and let your winners ride… lastly, I’d like to leave you with a bit of advice

 

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