I see the point about looking at each trade individually, but allow me to present you with a different real-world scenario: I will call my stock 'GOLD' and assume it behaves like GDX, but moves about 50 cents for every $1 move in GDX. Consider, please, the following situation:
- My BUY price is $34.50, which nets me a total of 9,155 shares. GOLD falls to $33.77. If I exit here, I incur a loss of $6,774, or, let us say, about 200 shares of GOLD…
- …At this point, GOLD must fall to $33.10 before I can use my proceeds to buy back in and 'erase' my loss. Obviously, if it falls further I am ahead; but if GOLD doesn't decline to at least $33.10 and instead moves back up, I must now buy back in at a higher price and add to my $6,774 loss.
- Now, in the current environment, GOLD could go up or down. I am going to assume that at some point GOLD will return to $34.50 - that's a pretty sure bet. The question is, how much further below $33.77 might it move first, and am I inclined on betting on that move? Again, to break even it has to hit $33.10. To make any real money, it has to hit $32.50 or so. My position is that, in order to risk the 'loss' of my 200 shares, I must be adequately compensated. And of course, that depends on the size/probabilities of a move downward.
My point is, if I were to look at this trade in isolation, yes, sell now before it goes lower. But that is not always the way to look at it in practical terms. I might suffer a bigger paper loss here temporarily, but there is really little chance of me translating that to a real loss - unless the bull in gold changes. And I am all about preventing losses. If you see anything wrong with my approach, I would appreciate (really) knowing.
1. We respectfully disagree. If GOLD falls to $33.77 then you have already incurred a loss. Your accountant may disagree, but this is how we view it and how you should view it (an explanation is below). Exiting the position changes your exposure, but not the loss. If you sold and bought back in a second (assuming the price didn't move and you were able to do so without a commission), would it change anything? Nothing at all. So just because you didn't exit the position doesn't mean that you don't have a loss.
Before we wrote the final version of the reply to this question we made a few earlier attempts but they were all unclear - that is until we realized that we should start with the definition of a loss. There are several ways to look at a loss and each has different implications for your money management. Even in terms of accounting, there's more than one way to look at losses and gains. Depending on the nature of the investment, unrealized (a.k.a. "paper") losses and gains may or may not be visible on companies' income statements (and they may or may not have tax consequences).
From a psychological point of view, the situation is even more complicated, because investors and traders will tend to do whatever it takes not to admit that they have a loss because they will (incorrectly) always associate a loss with their own personal failure. (The correct action is to realize that losses are inevitable and an inherent part of the investment/ trading process. But that is not intuitive, which makes it so difficult to apply in practice.)
Since people don't want to view themselves as those who have made bad decisions, they will "frame" the current situation so that it doesn't look like a failure.The human brain is creative and can come up with many excuses to protect an investor's self-esteem. The 2 most popular ways the brain does this is by blaming others (manipulation of the market?) and by looking at a losing position in a way that doesn't make it look like a losing one ("I didn't close the position so there's no loss"). The subject is tricky because manipulations can really occur and in accounting terms this definition of a loss (“no loss as long as a position is open”) can be correct.
So, what is a loss and what is not a loss? What definition should we use? Usually the best way to deal with any complicated matter is to go back to the basics and start the thought process from there. Why are we investing/ trading in the first place? In order to either make money or to protect what we already own. The practical definition of a loss that will help us achieve this goal will therefore be the correct one. Whether you are trading or investing, ultimately your brokerage account (or your personal notes) will simply show a series of transactions. You can refer to a few of them as "elections trading" or "looking for the major bottom trading" etc., but ultimately each of them will separately contribute to your overall profitability.
Does psychological grouping make any of them special, relative to the ultimate profitability or size of the portfolio? No. Does the associated happiness (after cashing in profits), fear (of losing a trade), or sadness (after taking a loss) affect long-term profitability? No, at least not directly. The only thing the portfolio size "understands" is the sum of outcomes of previous transactions. The outcome does not depend on the number of losing trades or the number of winning trades. Was there a series of small losses following a big profit? Or was there a series of small gains followed by one single loss? It doesn't matter as long as the final outcome is the same. Emotionally, investors and traders would much prefer the series of profits and one big loss than the other way around because they would have to deal with the pain of dealing with a "failure" just once, and they would feel happy many times.
Why is following this intuitive approach bad? In order to minimize the number of losses, investors/ traders will tend to close winning positions too soon (being afraid that winning trades will turn into losing ones, whose number they want to minimize), and they will tend to keep losing positions open too long in the hopes that these positions will eventually become profitable. This is exactly the opposite of what traders should aim for - small losses and big profits. Precious metals investors should be ok with the latter because gold and silver are in a secular bull market. However, “ok” doesn't mean making the most of it. If metals are likely to move lower, then by exiting a long position (regardless of its profitability or lack thereof) and reentering it at lower prices, one would increase their rate of return even though this could mean having one losing trade and one winning trade instead of simply one winning trade.
The goal of investing is not to avoid losses, but to make the most money possible in the long run (this by itself implies proper risk management). In fact, those with many losing trades can be very good traders. Those that hate taking losses will eventually lose a lot of money, because they will hold on to losing trades for a very long time just to avoid "recognizing" the loss. They simply don't want to admit to themselves that they have lost a trade. This is where perfectionism is bad for traders because one only needs one bad trade to lose everything - the one trade that is big enough. And it will be big enough if one lets it become that big by not closing it and not taking the loss while it is still small or moderate.
The above example revolves around "erasing the loss" and the loss itself, which suggests that "loss aversion" is in place. This is actually one of the emotional biases identified by behavioral finance. The result of this bias is becoming overly short-term focused and losing perspective on the whole portfolio, which can lead to overtrading, taking positions that are too risky, and the abovementioned cutting winning trades too early and letting losing trades become even worse.
2. We respectfully disagree once again. GOLD doesn't have to fall to $33.10 before you can buy back in and 'erase' your loss. If GOLD fell just to $33.50 and you bought back, you would still erase the loss (partially, but still) and you would be better off than by simply waiting out the move lower. So, even if we stick to the point of view in which we discuss adding to or lowering one loss, exiting the long position on a declining asset is a good idea.
It is much clearer if you view each trade separately. You are long but you no longer think that the asset will move higher. So you exit the position regardless of the price (whether you exit it at a profit or loss is not important at all - if it was profitable you would call that "taking profits off the table" and if it was a loss, you would call it "cutting losses"). When you believe that the position should be reopened, reopen it - whether the price is higher or lower than when you close your previous position. Simple as that. The point is that when you thought the price was going lower, you believed that you would have a better opportunity to reopen the position, so if you were correct, the odds were in your favor. By following this principle, you have to come out ahead if your estimations are correct. And this is what trading is all about - taking on a reasonable amount of risk in order to profit on changes in prices.
The goal of trading or investing is not to "erase a loss", but to make the most money in the end. If your aim was not to see yourself taking the loss then you could indeed achieve that by not exiting a losing position and defining a loss as only the closing position. This approach, although more pleasant psychologically, will lower your overall rate of return. In other words, you will pay for the "psychological comfort" with lower portfolio value. We strongly believe that by adjusting their approach one can improve the rate of return and at the same time still enjoy this psychological comfort.
- Practical advice #1: Once the position is established, forget the entry price. Seriously. Remember the reasoning behind the direction of the trade and be sure you know when you should close it (by stop-loss or other means), but don't pay any attention to the price at which you entered the trade. It doesn't help you in anything at all and can make you physically anchored to this level in some ways ("I have to wait for the price to get back to this level to come out even" is a good (actually, bad) example).
- Practical advice #2: Always ask yourself the following question: "if I hadn't entered this position earlier, would I still open it today?" If the answer is "no", then close the position. Simple as that. The fact that you have entered a position is no justification for keeping it open. Unless you’re the head of the Bank of England or you can have a similar impact on the market, the market doesn't care about the price at which you have entered the trade, and doesn't take that information into account when establishing a trend. And you shouldn't use it as a factor either.
- Practical advice #3: Never, never, never mix what you think about a given trade with what you think about yourself. No matter how dedicated you are to your investment and trading, and no matter how much you care about the financial future of yourself and your family, you are not your trades. Losing a trade or exiting at a loss doesn't make you a bad person, a loser, etc. The efficiency of any trader can only be determined in the very long term.
In a restaurant, you don't taste a meal before it's ready and served. A jury doesn't vote before all the matters have been discussed. Investment and trading are not one-time events. They are a process that often spans over several decades. What sense would it make to judge the cook after they have just added the first ingredient and what sense would it make to reach a verdict after hearing just one witness? None. Similarly, it's pointless to judge your actions by yourself by just one trade, or even after a few months.
Plus, in the case of investing and (most of all) in the case of trading, randomness plays a huge role - you can't blame yourself for a losing trade just because you lost it. You can blame yourself if you lost it because you didn't pay any attention to what was going on in the market, but if your reasoning was good and you made the effort (and since you are reading this right now - you ARE making an effort), then it's simply not your fault if the trade was lost.
Does it have to be someone's fault? People like to think so because that makes them feel like they control the situation, but that's simply not true. Finding the guilty and teaching them a lesson or punishing them may work in most areas of life, but not in trading.It can be the case, and quite often will be, that a losing trade will be nobody's fault. It's just how markets work. There are no sure bets and no riskless assets (cash is not a riskless asset in our view as it constantly loses value through inflation and currencies are not eternal), and trading is a game of probabilities. You have to lose a trade every now and then - that's not bad, that's normal and you should expect it. The fact that you care about your and your family's future by managing your money after having thought about it, and by always making trades that are well-justified, makes you a good investor/ trader and - in the investment-related aspect - a good person. Losing one or a few of the trades does not change that at all.
3. In our view, that's precisely the practical way of looking at trades. Paper loss is really… a loss. Instead of agreeing to suffer a bigger paper loss we suggest staying out for at least a part of the decline. Thanks to this, in accounting terms, you will have a losing trade and a winning one (instead of just eventually having a winning one), but your profitability will increase. Ultimately, the point of investing is not minimizing the number of losing trades but making the most money in the long run.
We are about preventing losses too. However, the key point is what we mean by that. The point is to cut losses by exiting current positions as soon as you realize you wouldn't reopen this position if you didn't already have it. The point is not to prevent recognizing and acknowledging a losing trade simply for the sake of not having a losing trade in accounting terms.
Summing up, the reasons for which we believe that treating each trade separately, looking at "paper losses" as "losses", and not focusing on particular trades and their results are all good ideas are: increased profitability and greater chances of detecting and mitigating some emotional biases (mostly revolving around "loss aversion") which could otherwise further decrease profitability and increase investment risk.
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