Most of us are aware that 95% of traders fail to make money in markets, it could be due to various reasons like not following a statistically tested and proven trading system that has an edge, even if they have a trading system, most of them don’t have the right discipline to stick to the same strategy when they face streaks of losses and finally very few understand about risk management, not every know “How much is too much”? When it comes to position sizing.
There was a famous behavioral finance experiment conducted by University of France, for several years they were researching on one particular human element risk appetite.
To do the experiment, they asked the volunteers to choose an answer based on a lottery system where one option provides them a guaranteed moderate win and another option given was a greater win with uncertainty.
They were asked these questions and choose which one they would prefer. With each experiment, the findings were the same, the majority of the participants opted to go for the smaller winning amount that are guaranteed, rather than going for a higher amount which is associated with uncertainty. This shows people tend to avoid situations that are too risky, people want guaranteed money even if it is much smaller.
After this experiment, the researchers slightly varied the question this time from making money to losing money. But with this new question asked, now people are willing to go for uncertainty, they are willing to risk more now. Earlier they opted for a guaranteed win, but now they want to take a chance, and most participants opted for a second option, where they are willing to take a 50% chance to lose $150. They think that they have a good chance of not losing, because it has only 50% chance, and they believe they won’t be on the wrong side.
The finding from the experiment was that there is an extreme aversion towards loss. People are ready to risk more when given a chance, when they were given an option to choose for high reward with uncertainty, most of them opted for low reward, because it was guaranteed one.
But the same people when given the option to choose higher loss with uncertainty or lower loss with certainty, they did not go for lower loss, instead they decided to take a chance and opted higher loss option with uncertainty.
Even a few months before I have posted the same question on Twitter as well. The results were similar to what University of France’s research result, more than 70% of them opted for guaranteed win when it comes to winning, but they were ready to lose a higher amount by taking a chance when it comes to losing.
This is the exact problem with most traders, they take a trade and if it did not go in their favor, instead of keeping a fixed stop loss and coming out with a loss, they take a chance and wait further without any stop loss, with a hope that the stock could bounce back, and they can eliminate the loss. But that is only going to do more damage to us. This is also one of the prime reason, where retailers are the largest shareholders who hold stocks like DHFL, YESBANK, RCOM etc where they took a chance with uncertainty and decided to hold these stocks hoping one day it would recover instead of booking loss at certain amount and coming out of the trade.
In trading only handling the risk is in our hands. We can only control how much we can lose in a trade, how much we can gain in a trade is in market’s hand. But most traders think the other way, the first question they ask themselves before placing a trade is “How much am I going to make in this trade?” most beginners never ask “How much am I going to lose in this trade, if it goes wrong?” The moment you put forth this question first, you can see a drastic change in your trading result.