Trading Psychology in 60 seconds – Regret Avoidance

A lot of trading psychology has been learnt through meticulous research and study, by people such as Amos Tversky and Daniel Kahneman and more recently, by Brad O’Dean. If we skim the cream off the top of their studies we find that investors and traders routinely avoid selling losers to avoid feelings of regret and WHEN they do this so that they often end up causing themselves greater financial harm and psychological distress.

Ergo, here we are looking at the CTD chart in July 2020 (CTD is listed on the ASX). It’s been on a downtrend for two years falling from $33 to $12 today. All the research tells us that if we were a buyer at $30 and are still holder today, we are doing so for several reasons. Either we are being duped into holding on by someone else, such as a financial advisor or, more likely by our internal psychology.

We avoid selling now because:

We cannot face taking the financial hit to our account.
Because we cannot face up to the fact that we are wrong. We bought at the top and now have to sell at what looks like the bottom.
We avoid selling because we hold out hope that the stock will once again trade back at $30
There is a financial penalty that regret avoidance has on our account. We may be holding onto a losing position for years. The position may even get worse and we may end up losing even more money. We engage in wishful thinking about exiting at a higher price and once we let do that, we become psychologically weakened when it comes to all future investments/trades. We lose out due to opportunity cost – that is the cost of missing out on other winning trades and being unable to use the money tied up in CTD because we avoid cutting our losses, freeing that money up and playing for better position elsewhere in the market.

You can avoid being a regret avoider by doing the following: accept that its ok to be wrong, accept that you will be wrong, accept that there is a financial penalty for being wrong, accept that the best financial penalty for being wrong is a cheap financial penalty, have a trading plan which identifies risk and a price point which identifies to you that you are wrong while at the same time, allows you to exit with a small financial penalty.

Trading Psychology in 60 seconds – To be a trader is to be a social loafer

Most of us are not social loafers. What’s a social loafer? It’s someone who tries to do as little as possible of the hard graft in order to get a job done, especially in a group situation. Remember doing those group projects at high school and you always got stuck with the class loser in your group? The loser, who you knew, was not going to bring anything to the table, but at the end of it all, he would share in the great mark you got for the project – which you seemed to do most of the work for. The truth is, when quizzed about our attitude towards social loafers, most of have complete contempt towards them. We feel like they let the side down and often we feel like we were the only one who could see them letting the side down and because of that, we then get annoyed when they get equal share of the glory for a job well done.

The social loafer theory states that as a work group gets larger in size – you know, as more and more people come on board to work on a project, that often an individual’s personal contribution decreases disproportionately to that group size. There is a perceived diffusion of personal responsibility to go above and beyond with personal time and effort as the size of the working group increases. Now you can see the similarities here with the market can’t you.

The truth is, in the market, to be a trader is to be a social loafer. And as I said at the start, most of us – by work ethic and breeding – we all want to contribute to society and therefore are not social loafers by nature, so the idea that, “to be a trader is to be a social loafer” that can be a difficult concept to comprehend or even to accept.

In the market the work group is everybody else – except for us. That includes, fund managers, mum and dad investors, day traders, fundamental and technical traders and investors – give everyone a label, it doesn’t matter because to be a trader is to sit outside of all these other participants and to simply do a disproportionate level of work but ultimately, get a maximum level of glory (profit) as possible.

We might be only one of a hundred buyers at a certain price level. We will definitely be only one of a thousand buyers who collectively help to move the share price. But that’s it. After that, we ride on the coat tails of the collective spirit where others do the work, but in theory, we get the profit. For many commentators and money managers, this social loafing of day traders and short term traders is a bug bear for them. You can hear it in their disparaging comments. You can hear it in the quotes that they sprout time and again such as “its time in the market, not timing the market” that works. God forbid, I even recall hearing a commentator on the old Your Money, Your Call TV program suggest that if you don’t hold onto a stock patiently when it decreases in value, then you don’t deserve to profit from it when it begins to trend upwards again. But to be a successful trader or investor, we must avoid those downtrends and surf the uptrends like a social loafer in dreadlocks. Remain aloof from the market – sure research stocks and the economy – keep abreast of everything, but by all means, be a social loafer without conscience and without care for the group.

Trading Psychology in 60 seconds – The Disposition effect

In the book called Reminiscences of a Stock Operator, Larry Livingston our hero of the story, committed what we now know as the disposition effect, when he held onto his position in cotton which showed him a loss, but sold his position in wheat which showed him a profit. He came to the conclusion that this was the worst speculative blunder that anyone could ever make in the market.

Consider shareholders in stock code ABC – down 25% in a day. How many of them will continue to hold? It is a tough call to ask anyone to sell a position which shows such a loss. Many holders will be carrying much larger losses because this thing has been at $4.40 12 months ago.

So what can you do?

First of all, you make yourself mindful of the disposition effect and with this in mind you establish investing or trading rules that are directly related to stopping you from finding yourself in this predicament.

We do this by not buying into downtrends for example. We focus on the economic fundamentals of not just the company but the broader economy in which we find ourselves. In a COVID 19 world, this would mean many people would be holding onto travel related stocks and suffering from the same effect – holding onto the Webjet’s in their portfolio, but offloading their ZIP or Afterpay shares which are showing them a profit.

You can take smaller position sizes as a general rule and work out a worst case scenario and see if and when this scenario unfolds, what impact it can have on your overall portfolio.

Maybe you limit yourself to only one stock per sector, such as one building company or one bank and so on, because we often see how bad news affecting one bank, always leads to contagion in other banks. But we are not your financial advisor. We don’t know what is best for you. But we suggest, making the worst speculative blunder that anyone could ever make in the market, is one blunder you should surely strive to avoid.