Investors naturally look at their investment decisions in terms of how much money they may make them. Only in a conscious effort do we analyze the possible bad outcomes before we take a decision and in the heat of the moment this step is often forgotten – especially when the opportunity seems to be very good. If our positive expectation does not materialize however, our thoughts completely turn around and painful losses are all we see now – often paralyzing us with thoughts about how we could have avoided taking the „bad“ decision in the first place. We ask ourselves how we can get out at break-even – essentially trying to return to the state we were in before we took the decision.
We all realize that trading and investing is a game where we have to accept losses as well as gains. It is an environment where a „good“ decision is one that bets on an outcome that has a higher than average probability to yield positive results and where we shouldn´t judge the quality of the decision on any individual outcome. But this realization doesn’t make it easier to deal with losses in practice. Over time I have come to look at each individual trading decision through a lens that allows me to better see the future as a range of possible outcomes (rather than myopically concentrating on the one outcome I wish for most):
How does my decision minimize possible future regrets?
Most people agree, that in practice trading and investing is to a large degree a psychological game. Once we mange to filter out much of the informational noise, it is easily possible to find many ideas and strategies that make sense, have worked in the past and look robust enough to very likely provide good returns in the future. But the practical implementation of these ideas is a whole different ballgame: seeing a model play out over time in studies or our own backtests is completely different from executing it in real time – sticking to a strategy over time proves to be extremely difficult.
Balancing fear and greed
The majority of investors and their decisions are driven by fear. Both loss aversion and – just as much – FOMO (fear of missing out) trigger strong emotions. We question every decision we make: “Why didn’t I lose less?“ or „Why did I miss those stelar returns?”. Unfortunately, a lot of the time these emotions lead to bad decisions, which cause our portfolio to underperform – mainly this materializes in the form of taking profits too early (another strong emotion is the urge to avoid losing what we have made) and letting losses run on for too long, because we are paralyzed by them.
The problem for most of us is, that it is hard to hold opposing scenarios in our minds simultaneously at the best of times (when our thinking is cool and rational). When making trading decisions these diverse possible future outcomes are so emotionally charged, that our concentration is drawn to the one dominant scenario like a magnet, tuning out all other possibilities: when taking a trade the possibility of great profits is at the forefront of our minds, but when it goes against us seeing red numbers swamps all other thoughts.
This can partly be mitigated by using a strategy with a longer time horizon, where we simply have to be less involved and make fewer decisions. But when things really go haywire hardly anyone can avoid to be influenced emotionally by what is happening around us.
What I have come to realize over time is that a small psychological twist works very well to get into the right state of mind to make balanced decisions. Rater than overconfidently picturing the money a trade might make me (as if this was quite certain to play out – which usually leads to taking on positions that are too large), nor being paralyzed into not taking the trade by fearing a possible loss (this usually occurs after experiencing a string of losses), I look at how I can minimize my future regrets. This point of view automatically balances the extremes of fear and greed as I can quite easily look at the different possible outcomes in the form of “what if“ scenarios:
- what if I’m right: how much will I regret not betting a lot to make the most amount of money possible?
- what if I’m wrong: how much will I regret losing a certain amount – what can I tolerate?
- and also the many different paths in-between, that make trading so difficult – seldom the outcome is reached in a straight line.
I can now make a balanced decision considering the range of outcomes, their probability of occurring and visualizing my possible reaction to different scenarios in advance. It even makes it easier to consider taking opposing trades simultaneously – for example considering possible market moves over different time frames when actively hedging a long-term portfolio through medium-term market swings (a practical implementation I will go into in my next post).
The question really is: what do we – as individual investors – value most: optimal returns or rather minimal regrets – balancing both missing out on gains and the possibility of losing money?