If you are an active trader or investor and find yourself holding on to losing positions, you are not alone.
Behavioral-finance research indicates there is a strong tendency for traders and investors to sell winners too soon and keep losers too long, even though a rational trading plan should motivate us to prune the losers and let the winners run.
In the battle of these two contrary motivations, why does the irrational one have so much influence?
It’s All About Dopamine
First, we naturally focus on our winners because winning generates the feel-good chemical dopamine deep in the brain. The more we pay attention to our winners, the better we feel, so our winners become our darlings and our losers are the forgotten “step-children.”
Second, dopamine is the brain chemical responsible for our sense of motivation, so we are doubly motivated to do things that boost it. Dopamine is a very powerful drug. Selling a winner is like a mini-epiphany for the primal brain. Just as Prozac is a serotonin reuptake inhibitor (so it boosts serotonin) cocaine is a dopamine reuptake inhibitor. In other words, dopamine surges can be addictive.
Third, Hebb’s Law says that neurons that fire together wire together, so we tend to repeat the behaviors that felt good in the past. Selling winners too soon becomes a habit rooted in the basal ganglia, an area of the brain that we have virtually no conscious control over.
And Hopamine
Fourth, dopamine has a psychologically slippery by-product – hope. The hope that our losers can one day elicit another epiphanic experience, however delayed, keeps the poor performers in the portfolio. Why is it so easy to imagine their resurrection and triumph?
It turns out that anticipation of a positive result (a win), generates more dopamine than the actual win itself. Whenever we ponder a possible positive outcome, we self-medicate. This is what kept primitive hunters motivated on long treks and it keeps investors and traders hopeful of a turnaround in portfolio slackers.
The Joys of Denial
Lastly, we have to face the loss in order to eliminate it. But a focus on losses causes dopamine levels to plummet. This makes one’s world feel bleak and hopeless. It’s easy, therefore, to make the tactical choice to shift our attention away from losses for as long as possible. Unfortunately, that tends to erode the bottom line.
The Prescription
Chose realism over hope. Proactively create rules to manage losses, so you don’t get trapped by your all-too-human default method, which is to ignore them. You can do this once you realize that managing losses has more impact on your bottom line than any other aspect of your investing and trading behavior, including picking all those great winners.
