Martin Lee @ Sg
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The Psychology of Pain in Cutting Loss

How many of you can relate to this?

Bought a share at $10.

Price goes to $9.50

Should I sell and cut loss now?

If Sell, pain = 10%
If hold, pain = 5% (there is still hope)

Decision = hold

Price goes to $9

If Sell, pain = 20%
If hold, pain = 10%

Decision = hold

Price goes to $8

If Sell, pain = 30%
If hold, pain = 20%

Decision = hold

Price goes to $7

If Sell, pain = 40%
If hold, pain = 35%

Decision = hold

Price goes to $6

If Sell, pain = 50%
If hold, pain = 49% (pain is getting almost unbearable)

Decision = hold

Price goes to $5

If Sell, pain = 60%
If hold, pain = 65%

Decision = sell (If I hold some more, it will continue to drop and there will be more pain OR I must recover whatever money I have left; I cannot afford to lose more)

As it turns out, the first cut is the least painful but because of the way we are wired, it is also the most difficult. We have a tendency to choose the decision that leads to less pain. While this is essential to survival, it leads us to make a lot of wrong decisions in the financial markets.

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7 comments
James Tan says 9 years ago

Hi Lion,

If you bought at $10 and sell it for $9.50, why is your pain below at 10% instead of 5% arithmetically in the said example?

In stock trading, it is a good practice to set your stop loss at 20-25% of the stock price, so as to make it mechanical, with no emotions. Target is 100% or with trailing stop, once the market is in your favor. Usual or normal daily stock price flutuation is between 1-20%. So, if your stop loss is between this range, you will be wipsawed right & left.

To have this stop loss, one must have a robust trading system, which can give proper buy/sell signals in min 60% of the time. One must learn or manage to control the market rather than the other way round, unless you want to turn short term trading to long term investment, as in buy & hold or hope.

It is the sentimental nature of stock markets to fluctuate daily and how should one manage this fluctuation, so as to overcome one’s emotion in trading. Do you not agree?

Reply
    lioninvestor says 9 years ago

    Hi James,

    The percentages are just arbitrary. Can’t really measure them but my point is more to show that initially, the pain of cutting is more compared to the pain of holding on.

    Anyway, just a side note. According to prospect theory, losses have more emotional impact than an equivalent amount of gains.

    This is because people value gains and losses differently. Thus, if a person were given two equal choices, one expressed in terms of possible gains and the other in possible losses, people are more likely to choose the former – even when they achieve the same economic end result.

    http://www.investopedia.com/university/behavioral_finance/behavioral11.asp

    Reply
Jasmin says 9 years ago

Human beings are emotional creatures and I am one who can’t bear to cut loss.

Reply
Jack says 9 years ago

As what Rod Stewart sang “First cut is the deepest…” and yet…

Well, to this day, I am still haunted by when to cut loss and sometimes when I do, the price reverses. There are occasions when I told myself I’m lucky to cut loss. Anyway, no easy answer and part of the problem is the high commission costs. Just cannot afford to enter and exit frequently or else the commission costs would become a huge expense. Just adding up commissions alone over a year will tell you how much you ‘loose’. Just like the casino; you ‘loose’ $100 even before you put on a bet. Well, I guess that’s the price to pay for entertainment. For some, it’s more thrilling than F1.

P.S. Don’t mean to pick on numbers but I don’t quite understand how sell pain and loss pain are not the same; e.g. 0.5 loss out of $10 should be 5% for both hold and sell?

Reply
    lioninvestor says 9 years ago

    Hi Jack,

    It’s just some hypothetical numbers to illustrate my point.

    At the initial loss, the pain for selling is actually higher than the pain for holding on, so most people will hold on. This is because when you sell, you realize the loss. If you hold, the loss is still a “paper loss” and there is hope that it will not be an actual loss eventually.

    Reply
      Jack says 9 years ago

      Ah I see.
      An even greater pain is when you sell at a loss and the price reverses dramatically.
      Slowly coming to grips with this….
      Thanks Lioninvestor.

      Reply
        lioninvestor says 9 years ago

        Yes, that is why “realising” a loss will usually give a higher pain than holding on, as we will be afraid that the price will reverse after we sell.

        It is only when the price has gone down so much that we will just start to extrapolate the future price movement downwards. At that point, it makes sense to sell as holding on means a lower price and more pain.

        Reply
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