As a part of the personal coaching programs that I do with a few clients, there is one aspect that I wanted to discuss in the blog as it brings out an important point that people should become aware of. Not that they are not but then, somehow, they tend to forget. Look at the three scenarios below.
- You have a long position in Tata Motors at 335. It moves up to 346. You think about taking profits but then argue that there is more possible here as recent high was above 400 levels. Hence you decide to hold on and then the stock falls intraday to 336.
- You went long in Century Textile at 534 as you felt the recent bout of correction was over and the stock exceeded a two day high. So expecting the rise to continue you went long on a breakout expectation. The stock did not move ahead and dropped to 524 by the close. You continue to hold.
- You were long in Reliance from the earlier day at 1011 and saw the prices move to 1020 during the day. Since you are bullish, you did not square up. But you decided to put a stop at 1001 to be on the safe side. The market falls towards the end of the day and your stop is hit in the last five minutes of the day.
Read those situations and think of how you would feel with each of those situations and write those down on a paper. Be truthful. Read the balance of this blog after you have done this.
You may have had three different feelings with the three situations or perhaps two or maybe just one. In the first one you still have a small profit of about one point from your entry. In the second one you have a mark to market loss of ten points but your expectations are intact. In the third case you have a loss of ten points at the end of the day. So are all situations different? Seems so, doesn’t it? Look at it again.
Aren’t the situations really the same? In each of them you have a ‘loss’ of ten points. In the first you lost ten points from the high price. In the second, you have lost ten points from your entry price. In the third you have lost ten points once the stop was hit. So all three situations are same as far as the monetary aspect is concerned! But the mind thinks of it differently.
The most hurt is felt in situation three- because of the “booked” loss. In the first situation even though the same amount of money has been ‘lost’ (346-336), the mind chooses to focus on the small gain (335-336) and encourages you to hold. In the second situation you really have just a loss but it is one which you are not willing to admit to- because of some misplaced faith in your assessment. The reality is that you have a ten point loss but the reality you create is that it is not really a loss but just a temporary pullback and ‘ soon’ the prices will climb higher!
Loss aversion behavior and insticts make us feel that a real loss is more painful than a notional loss. That you did not get the ten points as profit means the same as being stripped off ten points with the stop loss being hit. But a loss is a lot more painful than a denied profit. The situation is the same but the response is opposite!
Our tendency to avoid losses causes us to make silly decisions and change our behavior simply to keep the things that we already own. We are wired to feel protective of the things we own and that can lead us to overvalue these items in comparison with the options.
The way to get around this is by, first, becoming aware that we are doing this in almost every area of our life and then, second, make conscious efforts to understand how similar so many issues are even if they appear to be different basis the way we see them. In the markets, where rapid decision making is mandatory, these kind of differential thinking create problems by moving us towards wrong decisions (holding on to losers) or not applying prudent rules (trailing stops etc). These are learnt ways of thinking and hence any effort made in that direction will lead to a definite improvement to your bottom line.