Part 1: Making money on the markets goes against nature
Why we cut our winners
Part 2 How to re-write the story of stop loss
1. Accountability: take responsibility
2. Reframing stop losses
3. Identity association
- It becomes quantifiable and measurable: one trade is random. 100 trades are a data sample.
- It removes the incentive to cheat: being right is no longer an individual trade decision. You can lose money and be right. In fact, this association is stronger than the outcome orientation. It involves the neo-cortex in relationship to the dorso-lateral cortex (siege of identity). It literally rewrite the neural pathways to your identity
4. Clarity: Stop loss is a price, not a fundamental story, not a valuation exercise
- Stories: prior to becoming a superstar with Emotional Intelligence, Daniel Goleman wrote an even more interesting book about the lies we tell ourselves. He argued that self deception is a built-in feature that covers its own tracks. We rationalise our bad choices. We will change our beliefs in order to match our actions. If You find excuses to avoid the gym, then You will fabricate excuses to allow losers in your portfolio.
- Valuations: Earnings estimates are notoriously inaccurate and jumpy. Forecast accuracy for analysts earnings estimates 1 year out within +/-10% range peaks at 25%, half a coin toss !
- Stop losses are necessary to calculate position sizes. If You do not set a limit on how much You can afford to lose, You may fail to appreciate what the market has in store for You
- Emotional interference: Once we enter a position, emotions kick in. Think of it as a prenuptial agreement. Commit to a price in writing, write it close to entry cost and price. Do not trust your brain with some abstract stop loss price. Your brain will renegotiate and it will trick You into a suboptimal decision (marketing buzzword for stupid mistake).
6. Pre-mortem: enter each as if You expect them to fail
- Conservative position size: if you enter a trade expecting it to be a stopped out, You will naturally take smaller bets. You will stay out of illiquid issues
- Pre-packaged grief: we normally expect trades to work. When they don’t, we grieve our way to stop loss (Kubler-Ross). We negotiate with the inevitable. Now, if we expect every trade to fail, those which work will be good surprises. That do not perform as expected. It removes the emotional toll.