Cut Your Losses, Let your winners Run!


Investor Izzy Friedman said “You can’t make big money, unless you think big money”. If one’s predetermined goal is a ten or twenty percent gain, for instance, it would seem improbable for one to hold on for many hundreds of percent gain.

Q1. You are offered a choice between two outcomes:

a) You have an 80% chance of winning $4,000 with a 20% chance of winning nothing or
b) You have a 100% chance of winning $3,000. 

Which of these would you choose? Make a choice before answering Q2.

Q2. You are offered a choice between two outcomes:

a) You have an 80% chance of losing $4,000 and a 20% chance losing nothing or
b) You have a 100% chance of losing $3,000. 

Which of these would you choose?

It turns out that the vast majority of people choose outcome B in question 1 and outcome A in question 2. In other words:

  • When we are winning we prefer to choose certainty. 
  • When we are losing we prefer to gamble.
These are our basic human instincts. 

If your gut instinct was to answer A to Question 1 and B to Question 2, you may have the instincts of a successful stock trader. Your instinct is to gamble when you are winning – in other words let your profits run – and to choose certainty – in the form of a definite limit on your losses – when you are losing – in other words cut your losses.

After carrying out a number of experiments, Kahnerman and Tversky concluded that people are naturally averse to losing and are more willing to gamble their way out of a losing position than to gamble in a winning position:

“It’s not so much that people hate uncertainty – but rather they hate losing.”

And it’s this natural hatred of losing that destroys most beginning traders. Trading success comes when we accept losses as a natural outcome of our endeavors and take action to make sure all our losses are small losses. This allows us to profit mightily from our victories, when we are courageous enough to grow them into large victories.

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