Thursday, August 21, 2014

Risk Aversion: The Trader's Handicap

Whatever failures I have known, whatever errors I have committed, whatever follies I have witnessed in private and public life have been the consequence of action without thought.
Bernard Baruch

You have often heard the sage advice, "Cut your losses short, let your winners run." Do you have trouble following it? Based on experience, you may think letting your winners run is easier said than done. It is not a good idea to let a losing trade mount losses to the point that the entire position is wiped out, but it's often not easy to hit upon a winning trade, and then, just sit back and let it ride. There's a strong temptation to take profits. You also are aware of the old cliché, "No one ever got hurt taking a profit?" Why you can not just let this winning trade run just a little longer. An analysis of your trade diary entries shows that if you could have held out a little longer, you would have made substantially more profits. Many traders hate to lose, and when they see a winning trade materialize, they want to lock in the profits and insure a win. Whatever you call it, it is still risk aversion. For some strange reason we are quite willing to gamble with losses, but when it comes to wins, we will take a sure thing over a gamble any day. Risk aversion is surely a weakness of many traders. If it can be beaten, traders can make significantly greater profits.

Why is risk aversion a problem? Why not just take small profits across a series of trades? It all depends on how successful your methods are. If you have methods that works 90% of the time, then you can take small profits and come out profitably overall. Unfortunately, most traders have a track record that is much lower than 90%. Obviously then for your economic survival, you must make larger profits on your winning trades. 

The sting of several losing trades can impact your pride and your ego. Losing even greater amounts of money by letting a winning trade turn into a losing trade is even harder to accept. Your conscience often tells you, "Sell now before it is too late." There isn't a simple solution to this problem. Profits can be hard to come by in the trading world; it's hard for many to risk losing a profit once they see they can lock it in by selling early. It may be hard
to swallow, but winning traders tend to be those kinds of people who actually enjoy risk. They are happy to see they have hit upon a winning set of circumstances and they can't wait to see what happens. They want to push the limits and see if they can squeeze out as much profit as possible. If you aren't a natural born risk taker, it may be difficult for you to hold out and avoid selling early. If you are the kind of person who feels uneasy while a position is in motion, you may have to make an extra effort to let your profits run. One strategy is to sell off increments of the position as it rises in value so that you can ease some of the psychological pressure gradually. By taking a little bit of profits at a time, you can feel an ever-increasing sense of safety.

It is essential that you trade with money you can afford to lose. The reason most traders are risk averse is that they are trading with money they need for basic living expenses. Thus, they are risking their safety and security, and this puts added pressure on them to perform. It isn't surprising that under these circumstances, one has trouble taking risks once a position starts to increase in value. You can come up with all the rationalizations you want, but if you trade with money you deeply care about, you'll have trouble risking it, and "to make money, you must risk money." You must manage risk, and that's hard to do if you don't have a large trading account. An large trading account allows the trader to risk as little as 1, 2, or3% on a single trade and still make a substantial profit. Risk aversion is a handicap. It's hard to beat it, but many do. If you are one of the few lucky ones, you will realize substantial profits and trade consistently and profitably.

Reprint from 2005 PrudentTrader Newsletter

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