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Managing Risk to Avoid Disaster

Right off the bat, I propose the following bet:

I throw a coin once. If it lands on 'heads', you win $100, but if it lands on 'tails', you lose $100.

Would you agree to play?

According to the concept of loss aversion, chances are that you would not accept this proposal. As maintained by psychologists Daniel Kahneman and Amos Tversky, the emotional pain felt by a financial loss is greater than the satisfaction derived from an equal profit. This is why a person will require a potential gain at least twice as much as a loss to accept to play.

As you probably know, in the market, this fact explains our difficulty in closing a losing position. An active trader will recognize the importance of cutting losses, but their ego will prevent them from acting in their own best interest. Whether it is their desire to be right, their need for control or their impression that they are above average, they will tend to hold an unprofitable investment despite the facts and arguments justifying its sale. In this regard, an analysis of the market activity of 8,000 brokerage accounts commissioned by Jason Zweig, a journalist with the Wall Street Journal, shows that 21.5% of clients never sold a stock that fell below its entry price!

In the same line of thought, for fear of losing a theoretical gain, an active trader will tend to take profits more quickly on winning trades. For example, using a methodology similar to the one described above, Terrance Odean, a renowned finance professor, found that profitable stocks that were sold by clients posted, the following year, an average return in excess of 3.4% to that recorded by non-profitable securities still held.

As a result, it is essential to manage risk while maximizing return. To do this, I suggest using a stop-loss order for each transaction. For example, I buy XYZ shares at $10 and then place a stop-loss sell order at $9. If the share price falls below $9, the position will be closed out automatically. Otherwise, I will keep it.

This way, the active trader acquires an asymmetric risk-return ratio, because the potential for gain is greater (the price of a stock can go up infinitely) than the risk of financial loss (the maximum theoretical loss is the difference between the acquisition cost and the price of the stop-loss sell order). On the other hand, active traders acknowledge that financial losses are inevitable, given the uncertain and random nature of markets (for example, Donald Trump's victory in the US presidential election, the Manchester bombing, the Home Capital Group and Aimia fiasco), which allows them to preserve their mental energy and reduce their stress level, conditions essential for maintaining consistency in the long-term results.

Obviously, all active traders want to achieve positive returns, which is quite normal. Unfortunately, the financial community generally issues recommendations for the purchase of shares and neglects the proper management of portfolio positions, particularly when these have unrealized losses. I encourage you to place as much importance on risk management as on the selection of securities, otherwise your performance will be as random as a game of heads or tails...

Sources:

  • Daniel Kahneman and Amos Tversky. Prospect Theory: An Analysis of Decision under Risk, Econometrica 47: 2, 1979, 263-291.
  • Jason Zweig. Your Money and Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich, Simon & Shuster, 2007.
  • Terrance Odean. Are Investors Reluctant to Realize Their Losses? The Journal of Finance, Volume LIII, no 5, October 1998.
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Michel Villa

Michel Villa

Speaker, stock market blogger and trading coach

Michel Villa

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