Why Most Retail Investors Lose Money— Prospect Theory
Investing mistakes are more common than most people think, it is enough to visit any broker website and you will see it written in bold on the homepage, “70% of retail investor accounts lose money when trading CFDs with this provider”. This 70% is even higher on some other providers websites, while at the same time, the market is overall having good returns year after year, so why not just invest in an index fund like S&P 500 and have a double digit return every year (the median being 12.36% over the last 50 years).
The prospect theory provides a good explanation on why the human psych is not made to prosper in trading. It is thanks to our psychology that we are more sensitive to losses compared to gains. So, if we made a trade and it is winning, we tend to close it prematurely in order to avoid losing what we have gained, while if that trade is losing we wait on it, hoping it will reverse and go our way. This behavior results in having small gains and big losses, so even if we are correct most of the time, this psychology effect results in an overall negative outcome.
As Daniel Kahneman, the author of prospect theory, said in his book, Thinking, fast and slow, that even when we know and acknowledge these kinds of biases we are still going to fail for them. The more emotional you are the more prone you are to these biases. So, the goal is not to stop this behavior since it is quiet hard to change how we are built, but rather to avoid situation in which we behave poorly.
Knowing your weaknesses is one step, avoiding them is the very next step. If you wanna have a healthy diet, you should not fill your fridge with delicious cakes. In the same way, if you want to have a healthy investing diet, you should avoid putting yourself in situation where your emotions will take over, and we all know how that might end. There are a couple of rules that should help :
- If you are not sure, do not use leverage. Borrowing money is a good idea only when we are sure about the deal, but most of the time there is speculation involved. By not using leverage, you might miss a big gain, but you will also miss the big loses, and that is the most important thing for our mental and financial health.
- If you were wrong, lose fast and lose gracefully. Decide before opening a deal, how much money you could afford losing on that deal, this loss should not represent a substantial percentage of the overall total, and when this limit is reached, it is time to take that small L and leave before it becomes a big L.
Finally, the best way to deal with high losses is to not be exposed to high losses from the beginning. Hedging your investments is meant to do that for you. There are many investment strategies that help in hedging your money, including Dollar cost averaging (DCA), and Indexing, to name a couple of the most used ones.
In a nutshell, Investing is more time, and energy efficient compared to trading, and also it leads to better outputs most of the time. All you need is a the good mix of strategy and patience.
