I am sure we are all familiar with the losing trade that becomes a long term investment. In fact, I have one in my portfolio right now: just to remind me of the terrible cost of not cutting losses.

The Psychology of Losing

Research by Tversky and Kahneman (Judgement under Uncertainty: Heuristics and Biases, 1982) showed that most individuals are risk avoiders when handling gains and risk takers when dealing with losses.

The first part of their experiment saw subjects receive $1,000 with the choice of a guaranteed gain of $500 or a 50% chance of a $1,000 gain. Over 80% chose the $500.

In the second part of the experiment subjects were given $2,000. They were then given the alternatives of a 50% chance of losing $1,000 or a 100% chance of losing $500. Around 70% chose the chance of losing $1,000.

The experiment concluded that the majority of people don’t let profits run and don’t cut losses. Completely the reverse of the psychology required of successful traders.

The Mathematics of Losing

There is a sound mathematical basis for cutting your losses early. As losses mount, the sum required to recover those losses increases exponentially.

 

Start $ Loss % Loss % Gain to Recover Loss
$1,000 100 10 11
200 20 25
300 30 43
400 40 67
500 50 100
600 60 150
700 70 233
800 80 400
900 90 900

It can be seen from the above chart that, at around a 20% loss, the exponential effect starts to be felt. Most stop loss advice falls in the 5% to 20% range, depending upon specific circumstances. For example, a stop loss for a speculative or volatile stock would be around 20%.

Conclusion

Cut your losses early, before any other consideration. You will be ahead of many other traders and importantly, ahead of the ruinous exponential curve.

Listen to two of the most successful investors/speculators of the early 20th century:

If you have made a mistake, cut your losses as quickly as possible

Bernard Baruch

The only thing to do when a person is wrong is to be right, by ceasing to be wrong. Cut your losses quickly without hesitation

Jesse Livermore

And from today:

I’m only rich because I know when I’m wrong…I basically have survived by recognizing my mistakes … you must recognize and admit your mistakes when you make them, cut your losses short, and move on to the next logical step.

George Soros

12 November 2014 Markets