Why You Are Limiting Your Returns, And How to Work Around Yourself

Jul 01, 2022

Most of us like to think we’re rational.

When presented with a choice, we generally use logic and reason to make the best decision possible with the information available to us.

Right?

Well, heaps of research into human behavior says otherwise.

Most of us tend to be far more emotional and susceptible to “cognitive biases” – common, subconscious errors in thinking – than we realize. And that’s particularly true when it comes to investing.

There are dozens of biases that can lead us to make poor decisions with our money. And because they’re hard-wired into our brains, they can be tough to avoid even when we’re aware of them.

But one specific cognitive bias is responsible for two of the biggest and most common mistakes many investors make. And fortunately, in this case, there is a simple way we can fight back against it.

Let me explain.

The cognitive bias I’m referring to is called “loss aversion.” It has to do with the tendency for the human brain to experience a loss more intensely than an equivalent gain.

In simple terms, loss aversion means that for most people, the emotional or psychological pain of losing $100 is much greater than the pleasure of winning or earning that same amount.

And again, this tendency leads us to make two common but serious mistakes.

You can probably guess the first one.

Mistake No. 1: Holding on to Losing Investments

We’ve all bought a stock or other investment that has performed terribly for one reason or another.

When that happens, the logical thing is to sell it and cut our losses to protect our hard-earned capital. If that investment should start to perform better in the future, we could always buy it back later.

But most of us don’t do that.

To avoid the pain of realizing a loss, we come up with all kinds of reasons or excuses to hang on. Even worse, we’ll often take even bigger risks – like buying more shares or using options or leverage to “juice” our returns – to make our money back faster.

We might get lucky from time to time with this approach. But it’s guaranteed to backfire in the long run.

In fact, I suspect this mistake is probably responsible for more individual investor losses than all others combined.

But holding on to losing investments isn’t the only way loss aversion can lead us astray.

Mistake No. 2: Selling Winners Prematurely

Again, because the pain of losing tends to be greater than the joy of winning, this phenomenon also drives many investors to sell their best-performing investments to lock in gains.

This mistake doesn’t necessarily seem like a big deal. After all, you can’t go broke taking a profit, right?

But this behavior can be nearly as costly to your long-term success as holding on to losing investments too long.

The reason is simple: Most stocks are lousy investments. Research shows that most of the market’s long-term returns come from just a small percentage of stocks that outperform.

By extension, most of the potential gains you earn are also likely to come from a relatively small number of winning investments. But this can only happen if you give your winners the chance to run.

We’ve all heard stories of folks who have made fortunes from early investments in world-changing companies Apple Inc. (AAPL) or Amazon.com Inc. (AMZN) that soared thousands of percent.

But for every one of those people, there are likely thousands more who sold those same stocks after a relatively small profit and missed out on life-changing gains.

In sum, loss aversion leads most folks to unknowingly limit their potential gains while simultaneously un-limiting their losses.

That’s a recipe for disappointment and terrible long-term returns.

The Simple “Cure” for Loss Aversion

Fortunately, there’s a simple way to protect yourself from this natural human tendency: Trailing Stop Losses.

Trailing stops are the foundation of the TradeSmith approach to investing. They help to dampen the emotion of selling losing positions. And they can give you the confidence to avoid selling your winners too early.

In other words, when used consistently, trailing stops allow you to flip this bias on its head: They help you limit your losses while un-limiting your gains.

And best of all, they’re relatively easy to use. You can calculate and track your own trailing stop losses with a simple spreadsheet or even by hand.

You can learn more about getting started with trailing stop losses right here.

As always, you can reach me directly with any questions or comments at [email protected]. I can’t respond to every email, but I read them all.