Picture this. You have always paid $3.00 for orange juice at your grocery store. One day, you arrive at the store and you discover that the price is $2.00. Now imagine that the next day the price has instead risen to $4.00.
You’re obviously happy with the discount to $2.00 and unhappy with the price hike to $4.00. But which emotion do you feel more strongly?
In the early 1990s, Hardie, Johnson and Fader asked this question and discovered that people feel worse when prices have risen than they feel good when prices have fallen. In economics-speak, consumers get more disutility from buying when prices have risen than the extra utility they get when prices have fallen.
In other words, people are hardwired to feel pain more strongly and thus avoid it at all costs. This tendency may explain why so many novice traders are unprofitable.
Between 1987 and 1993, a study was done on 10,000 traders to compare the percentage of winning stocks held that were sold and the percentage of losing stocks held that were sold. You can think about the winning stocks sold as traders booking a gain. Similarly, selling losing stocks was akin to realizing a loss.
The study concluded that traders tended to sell winners early while holding onto losers.
Furthermore, the study showed that winning stocks often keep winning! As a result, most people sold a winning stock too early and left money on the table that could have been made. Even worse, they opened themselves up to a capital gains tax by selling the winning stock.
Even worse than that, traders held on to losing stocks, which often keep losing!
When you’re stuck with a losing position, your cunning mind contrives to tell you if you never sell the losing stock, you won’t feel pain; you’re hardwired to hope against hope for the losing stock to miraculously turn around.
On the other hand, selling a winning stock means it’s party time: you feel good, you banked a winner, you can celebrate. Moreover, you’ve just guaranteed that you’ll never feel the pain of seeing that stock turn into a loser.
But as most of you know, selling your losers and holding on to your winners is one of the most basic axioms of successful trading; succumbing to your hardwired instincts and doing the opposite will make you unsuccessful.
Successful traders overcome this human tendency by using their decision-making authority to override their instinctive behavior.
Doing so won’t be easy. Like swinging a golf club, skiing down a mountain or swinging a baseball bat, the right technique does not often feel good initially because it goes against lifelong tendencies. However, with persistent practice, you can train yourself to do what’s right and become successful in trading.
Gareth Feighery is CEO and Co-Founder of MarketTamer, a stocks and options education company. Feighery has an MBA from the Wharton School at the University of Pennsylvania.
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