We continue our discussion on the topic of Human-Market Psychology Conflicts and address the issue of Loss Aversion.
As mentioned previously, the major cause of emotional/cognitive mismatch in trading is due to performance pressure and not being able to accept the probabilistic nature of trading.
So why can’t so many traders accept that losses are a natural part of their trading system when trading with real money in the market?
Clinical studies have shown that financial losses create about 2.5 times more pain compared to the pleasure that comes from winning the same amount of money.
This built-in neurological imbalance, known as “Loss Aversion” or “The Prospect Theory” is a type of cognitive bias which explains why traders hate losing so much.
This cognitive bias forces many traders to leave profitable trades or become unable to honor their stops, resulting in small losses to growing larger and out of hand.
If a trading system does not provide at least a 2 to 1 win to loss ratio, many traders’ brains will become “reward deficit”, which would make them irritable, lose focus, and feel unconfident.
This is the reason many traders constantly change their trading systems to avoid losses and can only trade comfortably a system that offers a high win rate.
If a trader gets into a large loss or drawdown period due to a series of cumulative losses, the pain can lead to a “Fearing the Loss” mentality, which is the mindset of trading-not-to-lose while at the same time unconsciously expecting to lose.
This loss avoidance mindset influences a trader’s mind and makes them more risk-averse, which compromises the reward to risk ratio of a profitable trading system, making it nearly impossible to stay in a winning trade to reap its profit.
For other traders, this may provoke their mind to engage in a subconscious emotional fight response, which would lead them to participate in revenge trading, adding to losing positions, and overtrading, which can result in major losses and margin calls.
As a result, aspiring traders are recommended to master a trading system that has a high probability of winning with a less chance of consecutive losses and drawdown, and to train their minds to become comfortable with losing.
Traders must learn to psychologically deal with loss aversion the same way top performers in fields such as poker, music, finance, sports, and business learn to overcome their natural loss aversion instinct.
To learn about the next major cause of emotional/cognitive mismatch that needs to be considered in designing a profitable trading system and its execution, please click on the next video.
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