1/ Why do we tend to hold on to losing trades?
Prospect Theory offers a satisfying explanation. The chart below plots utility based on gains and losses.
Prospect Theory offers a satisfying explanation. The chart below plots utility based on gains and losses.
/2 There are 2 key underpinnings to the theory: one, losses hurt more than gains (the lower end of the S-curve is more extended than the upper), two one becomes desensitized/experiences diminishing margin returns/costs (why it is an S-curve).
/3 Applying the general theory to trading, a PnL of -$1000 has a greater absolute emotional effect than a gain of $1000, even though they are equivalent on an absolute basis. We are prone to seek to avoid losses due to this. When a trade begins to show a loss, we feel pain.
/4 We are incentivized to stop feeling this pain. We do this by not closing trades even when it is in our rational interest to do so because we are seeking to avoid this pain by hoping that we get lucky and the position flips green.
/5 We are also willing to gamble financially because we are desensitized emotionally to the loss becoming larger and larger. We are willing to pay this cost for the chance to sit until the trade reverses.
/6 Moral? as animals we have evolved to be risk-averse. The innate state of our risk preferences is often in contradiction with positive expected value financial decisions.
