In the world of financial markets, every investor may face a situation where their entire portfolio or individual positions start generating losses instead of profits. Depending on market conditions, this situation can last for a long time, with the drawdown reaching significant levels. Many traders, even those with years of experience, may not be prepared for such events. Therefore, understanding how to accept losses in investing can be valuable.
From this article you will learn:
- The common psychological factors, such as Fear of Missing Out (FOMO), regret avoidance, and the endowment effect, that make it difficult for traders to close losing positions.
- Practical methods to help traders and investors accept losses, including using stop-loss orders, adopting the “three opinions” method, and analyzing the asset’s alignment with their investment strategy.
- The importance of understanding when to hold or close losing positions, acknowledging the emotional challenges involved, and leveraging strategies to make more rational decisions in the face of losses.
What to Do If You Incur a Loss
Experienced and knowledgeable investors and traders typically employ two approaches when dealing with losing positions:
- Closing positions when certain conditions are met. This could be triggered by a drawdown exceeding a predetermined acceptable level, the appearance of a trading signal indicating it’s time to close a losing trade, etc.
- Averaging down. This approach involves buying more of the asset as its price declines, which lowers the average cost of the position. Once the market reverses in the desired direction, there is an opportunity to achieve higher returns.
The second approach is often favored by long-term investors in the stock market. The main argument in favor of this strategy is that, historically, markets tend to recover and reach new highs after downturns. Here are some real-world examples:
- The most severe crisis of the last two decades, the “Mortgage Crisis” (2007-2010). It led to a 54% drop in the S&P 500 index. However, after bottoming out, the market experienced an 11-year continuous growth, with the index gaining more than 350% over that period.
- The “Coronavirus” crisis of 2020. The S&P 500 dropped by 35%. However, the drawdown was fully recovered by 2021, and the index went on to set several new historical highs.
Similar patterns have been observed after every market crisis, whether it was the “Great Depression” or the “Dot-com Bust.”
When Liquidating Losing Positions Is Necessary
There are situations where liquidating losing positions is necessary. For instance:
- The Dot-com Bust. It led to the bankruptcy and disappearance of more than 50% of companies in the sector. Investors holding their stocks lost a significant portion of their portfolios, and some even lost their entire investment capital. This could have been avoided with timely liquidation of losing trades.
- The Mortgage Crisis. The U.S. market began its recovery only in 2009. Investors who had timely liquidated their losing positions could have started profiting from that moment, rather than waiting until 2013 for the market to fully recover.
Based on this, the appropriate action when facing a loss should be determined by the investor’s risk profile and the funds available in their account.
- If a prolonged period of losses does not cause discomfort, and the investor has sufficient capital to weather the drawdown and even open additional positions at better prices (averaging down), they may choose to hold onto their losing positions.
- For others, the best option is to close the losing trades and wait for the right moment to re-enter the market. This approach allows them to quickly recover losses by making “correct” positions.
For those who do not close losing positions, the famous stock market trader William O’Neil once said: “The secret to making big money in the stock market is not to be right all the time, but to lose the least amount of money when you’re wrong.”
Why Is It So Hard to Accept Losses?
Earlier, we discussed how traders should act when facing losing positions. However, all of this is viewed from a rational investment approach and basic logic. Not all traders are ready to take such steps. Psychology suggests that the reluctance of a trader or investor to close losing positions may stem from several factors:
- Fear of Missing Out (FOMO).
- Regret avoidance. In trading and investing psychology, this term refers to a trader’s unwillingness to admit that the decision they made when entering the trade was wrong. Essentially, they can’t accept this fact and strive to constantly validate their decision because they fear losing confidence in themselves, their strategy, and their trading system.
- Endowment effect. This is another cognitive bias that occurs as a result of an investor becoming “attached” to their open positions. It becomes hard to let go, and this reluctance is fueled by hope for a market turnaround.
All these effects are compounded by the emotional responses typical of any person. Research by psychologist Daniel Kahneman has shown that the human brain’s reaction to losses is about 2.5 times stronger than to gains. This means that losing $100, for example, would cause about 2.5 times more distress than the pleasure gained from earning the same amount. Or, to put it differently (though this isn’t entirely precise, it captures the essence), the positive emotions from gaining $100 are comparable to the negative ones from losing just $40.
Thus, without making certain efforts, a trader is unlikely to learn how to accept losses. This isn’t dependent on trading experience, capital size, or understanding of market processes, risk management, and capital management rules.
How to Accept Losses
To learn how to accept losses, an investor can also use various methods:
- Remove the responsibility of closing losing positions. Delegate this task to your broker or exchange. When making a trade, calculate the acceptable loss level and set a stop-loss order. The key is to resist the temptation to move the stop-loss further into the loss territory — it should only be moved if the price is going in the desired direction.
- Use the “Three Opinions” method. The first opinion is already known—realizing a loss reduces capital, unbalances the portfolio, and is generally negative. The task is to find two more opinions, but in a positive light. For example, you can view the loss as adding to your market experience. Another positive aspect might be the availability of free funds to purchase a more promising asset. Additionally, a lower overall financial result reduces taxation, as personal income tax is only paid on the profits from selling securities. When two out of three opinions are positive, it becomes much easier to accept the situation.
- Analyze the asset’s prospects and its fit with your investment strategy. For example, consider whether it’s rational to continue holding the losing asset by asking, “Would I enter this trade at the current price level and under the current market conditions?” If, after careful analysis, the trader answers positively, they can continue holding the losing position, and perhaps even increase it while prices remain attractive. If the answer is negative, the trade should be closed regardless of the loss amount.
Thus, a trader or investor in financial markets must understand when to close a losing position and when it might be better to hold or even increase it by averaging down. If this is psychologically difficult, there are well-known techniques and methods that can help to calmly accept losses.