The Psychological Impact Of Loss

Tyler Durden's picture

Submitted by Lance Roberts via RealInvestmentAdvice.com,

For the third time in four weeks, the market was closed on Monday due to a holiday. Not only is this week shortened by a holiday,  it is also coinciding with the annual Billionaire’s convention in Davos, Switzerland and the Presidential inauguration on Friday. Increased volatility over the next couple of days will certainly not be surprising.

In this past weekend’s missive, I discussed a variety of “extremes” being registered in many areas of the market and particularly in prices. To wit:

“I have often compared market prices to the equivalent of “stretching a rubber band.” Prices can only deviate so far from the long-term trend line before a mean reverting event eventually takes place. Much like a “rubber band,” prices can only be stretched so far before having to be relaxed to provide the ability to be stretched again.

 

The chart below shows the long-term trend in prices as compared to its underlying growth trend. The vertical dashed lines show the points where extreme overbought, extended conditions combined with extreme deviations in prices led to a mean-reverting event.”

“This is shown a bit clearer below which compares the deviation of the S&P 500 from the long-term growth trend. Currently, while only slightly below the peak of the 2000 “dot.com” bubble, the deviation is at levels that have ALWAYS coincided with a negative mean reverting event or very poor, and highly volatile, forward returns.”

I know…I know. As soon as I wrote that I could almost hear the cries of the “perma-bull” crowd exclaiming “how many times have we heard that before.” 

They would be right. The problem with the majority of analysis, in my opinion, is the mismatch between long-term analysis and short-term time frames. The problem with long-term price analysis is the failure to predict short-term price changes. However, short-term analysis leads to psychological wear where analysts have spotted “Head and Shoulder” formations, “Hindenberg Omens,” and Puppy Monkey Baby patterns that have failed to predict a market change.

Of course, like “crying wolf,” when these short-term patterns and long-term prognostications fail to immediately validate themselves, they are summarily dismissed as being wrong, or just “mumbo jumbo,”  which often leads to unwanted outcomes.

The primary problem is the “duration mismatch” between most technical analysis, which is typically very short-term (minute, hourly, daily), and the outlook for investors which is in years. 

As a portfolio manager, what is important for me is the understand the longer-term “TREND” of market prices. By looking at weekly and monthly data, the trend of prices is revealed allowing for a better match between portfolio goals and related market risks.

During “bull markets,” prices are in a steady advance with corrections to the longer-term bullish trend presenting buying opportunities. When prices become extended from the trend, such deviations provide opportunities to take profits and rebalance portfolios.

Conversely, during “bear markets,” prices are in a steady decline with corrections to the longer-term bearish trend presenting selling, hedging, and shorting opportunities. When prices become extended away from the bearish trend, such deviations should be used to take profits in short positions and portfolio hedges.

This idea is shown in the chart below.

By using a 72-week moving average, the longer-term trend of prices is more clearly revealed. As stated, corrections to the longer-term trend during bull markets were buying opportunities, whereas during bear markets they were selling/shorting opportunities.

VERY IMPORTANTLY – note that at the peak of the previous two markets the change from a bullish to a bearish trend was denoted by the following price action:

  1. A break of the long-term moving average
  2. A rally back to the long-term moving
  3. A failure and a move lower in price than the most recent bottom.

While this occurred at the beginning of 2016, it was quickly reversed following rapid intervention by global Central Banks quickly intervening with a flood of liquidity. The markets have now resumed their bullish trend currently but are pushing the limits of historical advances as noted this past weekend.

The Psychology Of Loss

The problem ultimately comes down to psychology.

Last year, I wrote an article about the fallacies of “buy and hold” investing which received a good bit of push back from the community of advisors who tout that the only way to invest is to buy low-cost ETF’s and hold them long-term. As I penned:

“Let’s assume an investor wants to compound their investments by 10% a year over a 5-year period.

 

Math-Of-Loss-10pct-Compound-011916

 

The “power of compounding” ONLY WORKS when you do not lose money. As shown, after three straight years of 10% returns, a drawdown of just 10% cuts the average annual compound growth rate by 50%. Furthermore, it then requires a 30% return to regain the average rate of return required.

 

In reality, chasing returns is much less important to your long-term investment success than most believe.”

Emotions and investment decisions are very poor bedfellows. Unfortunately, the majority of investors make emotional decisions because, in reality, very FEW actually have a well-thought-out investment plan including the advisors they work with. Retail investors generally buy an off-the-shelf portfolio allocation model that is heavily weighted in equities under the illusion that over a long enough period of time they will somehow make money. Unfortunately, history has been a brutal teacher about the value of risk management.

Take a look at the chart below.

The current extension of the market above the 200-dma, combined with extremely low volatility readings and overbought conditions, have not been kind to investors over the last couple of years.

This overbullish, overextended market is also evidenced on a MONTHLY basis with prices currently pushing a rare 3-standard deviation extensions above the 3-year moving average. 

Sure, this time could certainly be different. There is just a really high probability it will not be.

But such observations rarely deter individuals in the short-term as our emotionally driven “fear of missing out” and the now ingrained belief the “Fed won’t let the market fail,” blinds us to a multitude of psychological traps. These “traps” are the biggest reason for underperformance by investors who participate in the financial markets over time.

  • Loss Aversion – The fear of loss leads to a withdrawal of capital at the worst possible time.  Also known as “panic selling.”
  • Narrow Framing – Making decisions about on part of the portfolio without considering the effects on the total.
  • Anchoring – The process of remaining focused on what happened previously and not adapting to a changing market.
  • Mental Accounting – Separating performance of investments mentally to justify success and failure.
  • Lack of Diversification – Believing a portfolio is diversified when in fact it is a highly correlated pool of assets.
  • Herding– Following what everyone else is doing. Leads to “buy high/sell low.”
  • Regret – Not performing a necessary action due to the regret of a previous failure.
  • Media Response – The media has a bias to optimism to sell products from advertisers and attract view/readership.
  • Optimism – Overly optimistic assumptions tend to lead to rather dramatic reversions when met with reality.

The biggest of these problems for individuals is the “herding effect” and “loss aversion.”

These two behaviors tend to function together compounding the issues of investor mistakes over time. As markets are rising, individuals are lead to believe that the current price trend will continue to last for an indefinite period. The longer the rising trend last, the more ingrained the belief becomes until the last of “holdouts” finally “buys in” as the financial markets evolve into a “euphoric state.”

As the markets decline, there is a slow realization that “this decline” is something more than a “buy the dip” opportunity.  As losses mount, the anxiety of loss begins to mount until individuals seek to “avert further loss” by selling. As shown in the chart below, this behavioral trend runs counter-intuitive to the “buy low/sell high” investment rule.

Despite all of the arm waving and pounding on the table by advisors touting long-term average returns, time-in-the-market, etc., the psychological impact of loss is all too real. While “buy and hold” investing has its appeal during bullish trending markets, the “impact of loss” on individuals is a far greater emotional pull. This is why investors tend to do everything backwards by “buying high” (greed) and “selling low” (fear). 

This is why managing “risk” always “wins” over the long-term by reducing the emotional pull to “do something” at precisely the wrong time. The reality of loss tends to be more than most can stomach and sentiments of “time in the market” will go mostly unheeded. This is, of course, why many of the coveted millennial investors have already rejected much of the Wall Street rhetoric after watching the devastation that wrecked their parents over the last 15 years.

You can do better.

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Iconoclast421's picture

The first chart basically says if we have another 2008 it means the S&P500 only drops to about 1300. If we have another 2008 3 years from now it means the S&P500 only drops to 1400. So says the 100 year trendline.

1980XLS's picture

Maybe. As long as you are just long the market, no individual names and zero leverage.

Notveryamused's picture

This is why young men make better traders - more testosterone - (offsets loss/risk aversion for one.)

Very few successful woman traders compared to men and very few successful older male traders compared to young men despite more experience.

AND among young men, those with longer ring fingers earn 600% more than those with short ring fingers. (Long ring finger is high testosterone exposure in the womb) http://www.telegraph.co.uk/news/science/science-news/4223545/Ring-finger...

Feminists will complain about gender pay gap in the city but it's a testosterone centric occupation.

1980XLS's picture

Maybe you just need a functional  Penis or cojones?

Paul Kersey's picture

The Goldmanites almost never lose. In 2013, for instance, Goldman Sachs had 236 profitable days of trading (and just 15 days of losses). Forget the charts, because the financial engineers, insider traders and HFTs can always win in the rigged market. It's the muppets that take the losses.

"In an interview on CBS News' 60 Minutes on Sunday to promote the release of his book called Why I Left Goldman Sachs: A Wall Street Story, Smith said that securing an unsophisticated, or "muppet" client was the top goal of the bank's salespeople."

Iconoclast's picture

Given that 80% of trading is now algorithmic testosterone is irrelevant. Quants aren't noted for their silverback, chest thumping antics. Open cry, dealers barking orders down landline phones, panic on the trading floors, it doesn't exist in any meaningful way anymore. Only in shitty spread betting firms, where useless retail punters are desperately trying to unwind from their punts before the wife realises they've spunked their savings, will you see neanderthals on phones looking like they're extras from The Wolf Of Wall Street.

Xena fobe's picture

 Interesting info. Probably true, I am female and very risk averse.

flaminratzazz's picture

dont worry, they got this.

wisebastard's picture

i would trade better with cocain or adderal 

Grandad Grumps's picture

Total B/S.

The banks control market price and they see it as their, and the entities that collude with them, job to steal money from people. It is a form of fraud as well as theft. They claim that the stock markets are free markets and through the use of useful idiots (such as the above author) to promote the idea that banks (the pros) are smart and individual investors (amateurs) are stupid.

In a normal free market increased demand increases price and increased supply decreases price. In the stock market it is the exact opposite. When demand is high to hold a particular equity, the banks lower the price and take the opposite side of the trade. When demand is low, the banks raise the price to pocket the increase in price for themselves.

This is stealing and only possible because the banks (through specialists and market makers) take the opposite side of EVERY SINGLE OPEN MARKET TRADE... and since they control price, banks such as Goldman Sachs and JP Morgan can go entire years without a losing day in the markets.

BabaLooey's picture

Agreed G.G.

HOWEVER....

The "little guy" can make money trading. I do. I do so consistently, and WITHOUT all the institutional horse shit either.

You MUST KNOW all the things you stated; that the "markets" are rigged against you. That it has been a rigged casino for years. 

BUT -  trade wthin yourself.

I trade FX.

Of ALL the trading books and effluvium I've read over the years, the one book that helped me the most was this one;

"Blink"

http://gladwell.com/blink/

NOT a "trading manual" - or anything close to it.

Give you one example of "blink-thinking". You've all done it. 

You and I know - in an instant, when you see a hot babe. You ALSO know - in an instant, when you see a ugly skank.

Claudia Shiffer

Rosie O'Donnell

The vast majority of traders OVER-THINK THINGS. Do mounds of research. Study charts until they fart themselves into a stupor.

I applied the fundamentals from "Blink" - but realized I already WAS that type of trader. 

"Blink" confirmed a great deal of my own thought process. I'm an intuitive trader. A rhythm trader. I applied what I was reading, to my trading at that time. It worked more often than not.

I would NOT stare at charts. I would "hide" them. Walk away - stay away. Come back to my desk - pull up the charts - give them one look - and trade what I saw. Or not. I still practice much of that today.

TAKE THIS MORNING. I was flat going into the morning. I woke up, read NOTHING, and simply looked at the charts.

I missed the USD sell-off - but - one look at the GBP charts - a "blink" - and I went long the GBP/JPY. Proper stops are always applied, and risk management is paramount, but I let what I SAW rule me - in THAT instant.

Banked 43 and 75 pips. Took me less than 2 minutes to do so; seeing what I saw, placing the trade, setting the stops, and walking away. Literally "hiding" the screen. I set one alarm; if it went my way by 40 pips, I wanted to know. When that went off, I closed 1/3 of the trade, moved by stop to cost, and let it the remainder run. Shrank the screen again.

Came back to it after market close - took ONE look - and closed the remainder out.

I'll see if I was "right" to close the trade tomorrow. Sometimes I am, sometimes I'm not.

Who cares?

Total "work time"? 20 minutes.

I looked at NOHING else, did not study (nor care) about PM May's speech (I knew she was speaking, but seriously, who wants to waste time and effort reading each fucking word she said and then diasecting it?)

All flat again. Since the 27th, up 11.3%. Was up 7.2% in December. 14.6% in November. ...and on and on.

Do I lose sometimes? Hell yes. But my winners vs. losers are 75/25%. 

Give "Blink" a read. Might help you. 

AND FUCK THE BANKS. WORK SMART - NOT HARD. 

 

 

Iconoclast's picture

You're trading on impulse and gut feeling, eventually you'll run out of luck and cash. Try to develop an edge based on risk and probability. Try to build a trading plan, risking perhaps 0.1% of your account per trade, aiming for circa 50% return per year (including compounding returns), with drawdowns never exceeding 1.5%.

Never holding trades overnight, although you can and will enter trades 24/5, some whilst you're deep in sleep but you're never concerned about losses, because your personal circuit breaker is 0.5% loss per day and it all must be fully automated.

Try to create a method/strategy/plan that a mini version of Renaissance technologies would run, do that and you're heading in the right direction.

BabaLooey's picture

Good for you.

I was trained by a long time bank trader, but that was to gain basic knowledge. Over the years I've looked at a lot of systems, and paid lots of clown bucks for stupid "strategies", coaches and trainers that weren't worth the lint in my pocket, and in the end - every time, I "come home" to my own comfort-trader-zone.

Now, I try to keep it simple all the way around. I see it - I trade it. I don't - I don't. I'll stay flat and wait.

Patience. Good trading is damn near boring. 

Greed vs. Fear. Risk on vs. Risk off. Applies to the Yen pairs, as well as the USD pairs. The "odd duck" is the USD/CAD. The USD/CHF is an inverse EUR/USD. I hardly trade CHF pairs. I stick to the majors, the major crosses, and don't trade what I don't know.

The last stupid trade I did was silver, back in 2013, and that lesson was costly. Never again. I strayed from my own reservation, and got shot. 

It's not "luck" I'm using. It's the combination of smarts, logic, proper risk management (I guess you skipped that part Iconoclast), and strict trade rules. I hardly ever go to bed with a trade on, and if so, it almost always is in-the-money, and profit stopped. I've left a chunk of change out there just offsetting to going flat - just for the piece of mind.

After 10 years trading, I'm one of the few still standing, from the ones I personally knew and were "gung-ho" years ago.

I also have nearly 3 decades of investment management under my belt. It helps.

I have my record-keeping. My print-outs.

I get asked to teach and train all the time. I am assembling a syllabus for an upcoming project.

I just turned down some Brit looking to get newbie traders "trading as fast as possible", and he wanted me to put together a short course for these newbies. All I did was send some of my results to him when he first contacted me, and he was chomping at the bit to "hire me". 

I declined. A rip-off.  These poor suckers that will take his bait are going to end up like freshly flown in recruits in Saigon circa 1966.

It took me time, money, and effort to become a consistently profitable trader. Commitment. Most don't have that. 

My way of trading you really can't teach. My project in teaching it will be face-to-face teaching and training. Not this over the internet, GoToMeeting effluvia. 

It's the way I was trained as a trader.

Iconoclast's picture

I've been a retail trader, I've been the other side of retail punters 'bets' for some time, I've traded markets for over 30 years. I can tell you two things with absolute certainty; firstly, close on 95% of FX retail traders lose money, and as a recent French authority's survey proved they generally lose circa €10K before giving up. Those who are profitable are generally in Asia and make buttons, but those relative buttons make a huge difference to their low incomes.

So in short, close on 100% of uk and USA punters lose, let me correct that, I'd say only 0.5% of retail FX traders in those countries make anything you could consider to be a modest living, consistently.

During the recent secular bubble there will have been many novice day traders who've bought the indices or miners, thinking the job is simple, they'll be rinsed (as they always are) once we endure corrections.

Secondly, during my time on the other side of the bets, I've only witnessed one recurring method to make money trading the FX markets, it's Occam's Razor simple and it involves full automation. It also requires discipline, patience, it's emotionless and has probability and strict money management at its beating heart. And because of its sensitivity to spreads and lagging platforms, it cannot possibly 'work' on any retail platform.

Xena fobe's picture

It hurts my brain just reading this.  Ouch. 

Xena fobe's picture

I am similar but I only trade index etfs.  My first instinct is almost always correct.  Our subconscious is constantly observing and calculating.  There are too many variables for the conscious mind to compute.  When I start consciously debating myself, I lose my bearings. No need for stops since I know the ranges the ETFs usually move in and what risk I can tolerate. I am a very small trader though.  Not going to get rich on it.

wow017's picture

Good article.  My one disagreement is that the investor needs an advisor. If we are talking Stocks, think very carefully. Most of these guys want to know your every penny and then want the right to get their highs playing with your money while having no responsibility if their highs create severe lows for you. 

Good rules for stocks [1] go in for the long haul - 10 years minimum. [2] do not invest more than you can safely lose [3] let it ride - ignore the ups and downs, [4] decide when you will take money out - for example you put in 1000 and whenever it gets to 1250, you remove the 250 and put into another stock, savings or sock.

You need to be in charge.  It is your money.  Your families life.  

 

 

OverTheHedge's picture

This sort of article is fairly often repeated, just never remembered. You are supposed to by low and sell high, but almost everyone does the opposite. My thinking for when you get a loss is to accept the loss,  revalue your portfolio, and then decide if what you are invested in currently would be attractive if you had cash to burn. I.e., if you have just taken a 30% loss on a stock, that stock just got 30% cheaper - do you like it now? Buy when there is blood in the streets etc. In other words, don't sell just because it fell over, because then you WILL buy high and sell low. That being said, the whole game is rigged, valuations are a joke, and I wouldn't touch any equities with yours, let alone mine. I learned 25 years ago that the entire investment industry, from top to bottom, is a scam to extract rent from sheep. Win, lose or draw, banks, investment houses, brokerages etc still make a profit off your money, and when they fuck up, they are bailed out with your money. I choose not to play, these days. Sleep better, and don't have the urge to hurt people any more, which is a bonus.

Xena fobe's picture

I thought this article was going to be about the psychological loss of the butthurt liberals. OT: just noticed the dollar is back up tonight and gold getting dumped.