The Loss Trap

By: 

Van K. Tharp Ph.D

Do you remember playing with a toy called the Chinese Finger Trap when you were a child? This toy is a woven straw cylinder with an opening at each end just large enough for a finger. Once you insert a finger in each end, you are in the trap. You pull to get out and the trap closes around your fingers. The harder you pull to get out, the tighter the cylinder compresses around your fingers. The more you struggle with the trap, the more ensnared you become. Only when you let go and relax does the trap let go of you.

Investment losses form a similar trap for most people—the Loss Trap. The more an investor resists losses, the more ensnared the investor becomes in the Loss Trap—a psychological snare with numerous hidden factors that keep people locked into it. The more the investor struggles with losses, the worse the losses become.

Consider the case of Brad, an investor who wants to make a killing in a speculative stock. First, he pays $5,000 for a stock, including nearly $200 in expenses. These transaction costs start the investment off at a loss, so Brad is already in the trap. He has passed a critical point in time, the point of no return, where thinking often becomes irrational and risk takes on its real meaning.

Soon, the stock goes down in value to $4,300. Brad thinks to himself, "I have a loss, but it will turn around.” These are normal thoughts, resulting from his natural inclination to justify his stock purchase. As a result, he reasons, "I can afford to lose a few hundred dollars more to make a nice profit.”  When people are in the Loss Trap, they avoid the sure loss and take an unwise gamble that often leads to greater losses.

The stock goes down further, so that it is only worth $3,800. Somehow, Brad reasons, the stock has gone down so far that it cannot possibly go down any more. He can afford to risk a few hundred dollars more to make back his stake. Brad has now lost sight of his original profit goal, if he had one, and just wants to break even on this trade.

What happens next? The stock goes down to $2,500. Our investor cannot give up now. His stock hasn’t been priced this low in years. Besides, he has “spent” $2,500 on it at this point.

His stock must have bottomed, so the risk of holding onto it is minimal—he thinks. He holds onto his investment and soon only has $500 left.

Each possible loss that our investor envisions is compared against what has already been lost. Each time he imagines that his investment has reached rock bottom, he can envision no further risk. The stock can only go up. He already has so much at stake that he might as well continue holding the investment. And with each loss the trap gets tighter. Unfortunately, the only way to get out of such a trap is to let go of the trade, but the investor often is financially exhausted by that time.

How Do You View Losses?

Various hidden factors are involved in the Loss Trap. These factors include a person's perspective on the loss, inability to accept the possibility of being wrong and misjudgment of extreme probability levels. Take a look at the following choices and determine which decision you find more acceptable:

Would you find a $200 expense acceptable if it gave you a 60% chance to win $350 and a 40% chance of no gain?

or

Would you take a risk that gave you a 60% chance to win $150 and a 40% chance to lose $200?

If you are like most people, you probably decided that the first risk was acceptable. After all, you could win $350 and not risk anything except expenses.

How did you feel about the second decision? Perhaps it did not seem as good. You only have the opportunity to win $150 and you could lose even more. Losing more than you can win is not as acceptable to most people.

But look at the two decisions again. Mathematically, they are equivalent, working out to an expected value of ($150 x 60%)-($200 x 40%) = $10. The apparent difference is that a loss is viewed as an expense in the first decision, while it is presented as a loss—which it is—in the second one. If you realized the two decisions were the same, congratulations. Hopefully, you are just as perceptive when real money is at stake.

Investors have a tendency to view losses as something other than losses and that keeps us from seeing the Loss Trap for what it really is. For example, virtually every investment you purchase will start out at a loss because of the transaction costs. If you are like most people, that money is an expense, not a loss, which puts you in the Loss Trap as soon as you enter the market.

Many investors, in fact, keep up-to-date records of their investment activity, but they do not include transaction costs in those records. They keep a separate record of their expenses. As a result, they allow themselves to lose money each year, because they view those losses as expenses.

Other investors continue to lose money every year because they view losses as tax write-offs.  Investors frequently boast that they limit their speculative losses to $3,000 each year, because that is the maximum allowed as a tax write off. Somehow, tax write-offs justify the continual loss of money in speculative investments. Those cannot be bad, can they? They put you in a lower tax bracket and allow you to get money back from the government.

Both of these examples illustrate how your perspective can influence your bottom line, namely: If what you see differs from "what is,” you will have difficulty making a profit.

Being Right or Making Money

People tend to deceive themselves the most. Self-deception occurs each time a person clings to a false belief, and everyone holds many false beliefs. Self-deception greatly increases the risk of failure since we really do not know what we are confronting. When we fail because of self-deception, we continually face the same problem over and over again because it has not been resolved.

Again, look at the example of Brad, the stock market investor. When he first fell behind by $700, he could not admit he was wrong and take the loss. When his stock continued to fall, he could not admit the possibility that it would fall any farther. In fact, the more the price fell, the more difficult it was to admit that it would go down any more.

Once people commit to something, they become extremely confident about their decisions.  For example, psychological researchers taught a group of people to read stock charts and then asked them to predict from another set of charts whether prices would be higher or lower a month later.  These trained forecasters were correct on 47% of their stock predictions—around chance levels—but their confidence in the accuracy of their predictions was much higher than chance—at around 65%.  In fact, they were no more correct when their confidence was high than when their confidence was low.

How about extreme confidence—those times when people are really sure they are correct? Research has shown that when people give odds of 100-to-1 that they are correct, they actually are right only 75%-80% of the time. So, although they rate their confidence at 100-to-1, the actual odds should have been about 3.5-to-1.

Once people commit themselves to a position, even if it goes strongly against them, they become fully ensnared in the Loss Trap. They are so confident they are right, that they are willing to bet more and more money in their misplaced confidence. Thus, Brad was able to lose $700, $1,200, $2,500 and eventually $4,500 to prove that he could not be wrong.

Judging Extreme Probabilities

Suppose you have a lottery ticket that gives you a chance to win a $50,000 prize. How much is the lottery ticket worth to you if the odds are 1 million-to-1 of winning? Actually, the ticket is worth five cents in terms of the probability of winning $50,000, but people all over the country are paying $1 for it. People rate probability chances as more significant at the extremes. In particular, an increase from 0% to 5%, and an increase from 95% to 100% each have more impact on people than a change from 30% to 35%. This is why people have a tendency to “go for the big one” even though the odds are extremely small.

Suppose you are Brad and you have a $4,500 loss on your stock. Let's further suppose that you are given two choices about the future. You are told that you have a 95% chance of losing your entire $5,000 and a 5% chance of getting all your money back if you hang onto the stock. Which would you do?

Most people would hang on, hoping to get all of their money back. The increased value associated with moving from sure loss (a zero chance of winning) to the improbable (a 5% chance of getting your money back) increases the attractiveness of taking a chance.

Mathematically, your chances in this same situation are not good. If you made this decision 100 times, you would lose $5,000 on average 95 times for a total loss of $475,000. In contrast, if you took the sure loss of $4,500 each of the 100 times, then you would lose a total of $450,000. Thus, you would save $25,000 or an average of $250 each time you took the sure loss.

Taking the sure loss frees an investor from the Loss Trap, but the more attractive option is to stay deep within its jaws.  Taking the sure loss seems less attractive than the hope that one's fortune might turn around by holding onto the position. And as you have already learned, people in the Loss Trap tend to overestimate the odds of "lady luck" suddenly turning in their favor.

The solution to avoiding the Loss Trap is simple. It constitutes a fundamental law of speculative investing: Cut your losses short!

But simple solutions are often difficult to follow. That is why those who follow them make large profits from the many who do not. In fact, many successful speculators lose money 60%-70% of the time, but their losses are generally small and their profits are generally large.

Unfortunately, most people have trouble turning small profits into large ones. Instead, they cash in their profits quickly and do not allow them to grow. 

 

 

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Last revised: June 17, 2008