How To Know When To Quit (Part 2/2)

Hello traders,

All the below are based on my preferences, I don't give any financial recommendations and I have nothing to sell you with this article.
I'm sharing content because I see a lot of traders being/becoming broke and I don't want you to be one of them.

Sharing the second part of this article posted yesterday


5. Know your limits and set rules around it

Set out the rules beforehand rather than waiting until you are in it.
Because you will not make good decisions then.

There are particular states where you’re going to feel suboptimal that have to do with your own physical state.

You’re tired, you’re stressed, whatever, but then there are also cognitive states where you’re going to behave sub-optimally.

And the particular cognitive state where you’re really going to behave sub-optimally is when you’re in the losses.

And the reason that you’re going to be a terrible decision-maker is, except for the part it’s going to cause you to be emotional, is that you’re going to want to get your money back.

And this is a really big problem for investors.

You start down a path, it starts to lose and you don’t want to sell, because you can’t get your money back.
That’s the moment that you go from a loss on paper to a sure loss.

It’s when it becomes a realized loss.

And that is a moment that we do not like.

And so we will come up with all sorts of reasons to think we’re being rational in continuing on, when we’re being completely irrational because we’re just trying to protect ourselves from having that moment of having to take the sure loss.

6. Loss aversion

Our loss aversion prevents us from selling investments at a loss.

But this extend beyond trading too.

Decisions should be made based on the future, not the past.

I think people are familiar with loss aversion.

We don’t like to start things that carry with them a chance of loss, even if we’re winning to the decision.

When you already have a loss on the books, or even a cognitive loss on the books, it was trading at one level and now it’s trading lower, we don’t like to sell.

In other words, this becomes loss aversion stops us from starting aka taking trades sometimes.

Of course this is irrational, because what matters is, is the next dollar that you spend worthwhile, not did you already spend a dollar.

We shouldn’t care.

7. Endowment effect

We value things we own, much more than things we don’t own.

Even though the opposite might be true.

It could be stocks, bonds or our IDEAS.

We wrap our identity in things and won’t quit despite the warning signs.

And then we also have the issue, which I think is really important for investors, you have something called an endowment. We value things we own, much more than we value things that we don’t own.
And it’s not just ownership over investments, we actually own the stock, or we own the bond, or whatever, we own the option, but it’s also our ideas.
And every time we invest, we have ownership over our thesis.
And here’s the interesting thing, is that when the thing that we’re doing is out of consensus, this is when it gets really bad.

So when we think about these issues of sunk cost, and sure loss aversion, and the way our identity gets wrapped up in things, and the way we have ownership over things, and the way that affects our inability to stop, you have to put a big huge blinking warning sign when the thing we’re doing is out of consensus.

9. The kill criteria

Think in advance the signals you might see in the future that means that it is time to quit.
To continue holding this investment, what do you need to see in the next few quarters or years?
Sticking to things too long denies us future opportunities.

Think in advance about what are the signals that I might see in the future that would tell me that it’s time to walk away and you will get better at it.

What do I need to see within the next quarter or the next two quarters from the way that this investment might perform?

Essentially think, “How long can I tolerate this, or how much time do I need in order for me to actually get the information that I would need in order to be able to make a decision?”
Figure out what that time period is and then figure, at the end of that time period

“What would I have to see?
What are the benchmarks that this thing would have to hit in order for me to feel like I ought to continue?
And if it doesn’t hit these things, then I should walk away.

Quotes of the day

- "Losses loom larger than corresponding gains" ― Amos Tversky

- "If we could be freed from our aversion to loss, our whole outlook on risk would change"― Alan Hirsch



I'll keep bringing a few articles like this every week because it helps me clarifying my thoughts AND giving back to the community makes me feel good about myself somehow :)

Thank you for reading
Dave