Van K. Tharp Ph.D
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
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.
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
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.
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.
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.
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.
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.
You View Losses?
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:
you find a $200 expense acceptable if it gave you a 60% chance to
win $350 and a 40% chance of no gain?
you take a risk that gave you a 60% chance to win $150 and a 40%
chance to lose $200?
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.
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
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.
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.
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.
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.
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.
Right or Making Money
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.
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.
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.
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.
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.
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.
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?
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.
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.
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
solution to avoiding the Loss Trap is simple. It constitutes a
fundamental law of speculative investing: Cut your losses short!
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
most people have trouble turning small profits into large ones.
Instead, they cash in their profits quickly and do not allow them