4. Sunk Costs

From a more general standpoint, the sunk cost effect applies to any situation where someone makes a decision based on what has already been spent, rather than the implications for the future.

This covers a wide spectrum of decisions, from corporate investment decisions to personal ones. In the former, the sunk cost effect manifests itself when managers choose to stick to a course of action because of how much it cost.

For example, a company doggedly electing to upgrade a $20 million legacy IT system that no longer suits their needs, instead of investing in a completely new IT system.

It is evident that the sunk cost effect is clouding decision making when you hear arguments such as “but we’ve already spent $20 million on the old system”, and/or “but we’ve spent countless hours learning to use and work with the old system”.

However, neither the $20 million, nor the amount of time already spent on the old system has any relevance to whether or not the legacy system can meet the corporation’s future needs.

That’s what makes the sunk cost bias so dangerous, it keeps our minds locked on the past instead of focusing on the future.

In the context of trading, the sunk cost bias shows up most commonly in making decisions to exit positions with a small, but manageable loss. For example, our hypothetical stock trader who went long AAPL at $145, has a decision to make when the stock falls to $142 – take a small loss, or hold on in hopes of a future rally?

Take a moment to put yourself in his shoes and think: what would you do if you were him?

If you were focused on the $3 per share loss and felt like exiting the position would be “wasting” that money, since no one knows if the stock will or won’t recover, then your decision has been clouded by the sunk cost effect.

The key here is to consider the future – if AAPL goes up again then all is fine, but what if it doesn’t?

The $3 loss can very quickly grow into a $5 loss, then a $10 one; and before you know it, your entire trading account is at risk.

What’s worse is that the larger the loss gets, the more entrenched the sunk cost bias becomes – if you were unwilling to “waste” $3, would you be willing to “waste” $10?

The sunk cost bias also compounds with loss aversion, making it even more difficult to cut your losses as they grow larger; since you’re now unwilling to make the loss real and “waste” the capital and time invested in the trade! 

Fortunately, all it takes to guard against the sunk cost bias is a little discipline. As with all other cognitive biases and their negative effects on trader’s decision making processes, the solution is a simple one – construct a trading plan with clear risk management parameters and stick to it.

Unfortunately, this is easier said than done, as many professional and retail traders learn at some point in their trading careers.

What ultimately separates the profitable from the unprofitable is not a magic crystal ball, but consistency in executing a well constructed trading plan.

It doesn’t sound sexy at all, but it’s what works.

5. Disposition Effect

The trading aphorism of “let your winners run and cut your losers quickly” directly addresses the disposition effect; which is less obvious and more harmful than its cousins, loss aversion and the sunk cost effect.

The disposition effect is more insidious simply because going along with what it suggests doesn’t feel wrong.

Think about it: you put on a trade, it registers a small profit which makes you feel good about yourself, and decide to exit and take the profit.

What could possibly be wrong with locking in profits early? Isn’t that the whole point of trading anyway? There’s even an aphorism to back this up – “no one ever got hurt by taking profits”!

Unfortunately, there is something wrong about taking profits early, and that is the trade could potentially yield much higher gains.

Of course, no one knows in advance just how profitable a trade will turn out to be. This uncertainty is what creates the fear of losing whatever small profits have been accumulated over a short period of time.

If this sounds familiar, it’s because this fear is driven by loss aversion. As such, taking profits early out of fear of losing them is succumbing to loss aversion, which isn’t optimal behavior for traders.

Why?

Because should your trading account be hit with a big loss, small profits will not be sufficient to get your PnL back to even. It doesn’t matter whether or not the loss is a result of poor risk management, not effectively guarding against cognitive bias, or markets going crazy; small profits can’t cover large losses.

Which takes us to the other half of the disposition effect, the tendency to hold on to our losses.

This tendency is the result of the sunk cost effect acting in concert with loss aversion, and is what destroys the trading accounts of most new traders. Small losses are emotionally and psychologically difficult to take as our natural disposition is to want to give the trade some time, to see if the market swings in our favor.

The problem with this approach, however, is that when the small losses start to snowball, loss aversion and the sunk cost bias make it even more difficult to exit.

We start to think, “if I’ve already lost $10,000, what’s another $1,000?”, and decide to stick with the loss making trade.

When the loss becomes $20,000 we start to tell ourselves, “I’ll exit the position when the losses halve back to $10,000”. Of course, at this point, this has a low probability of happening as the market has quite decisively moved against the trade.

When we finally do decide to exit the trade, or our broker decides to force us to exit it, we are left nursing a large loss.

If the loss is $20,000, and we are in the habit of taking small profits of $200, that would mean 100 small winners will be needed to make up for that one massive loss!

To be continued…

5. Disposition Effect

The first step is to recognize that the market is signaling something when a position is profitable or nursing a loss.

This means that, if a trade is profitable, the market is signaling that there is a decent chance of it continuing to be profitable. Likewise, if a trade is losing money, the market is saying that it will probably continue to lose money. 

Why is this the case?

Simply because markets tend to move in three general ways – trending up, trending down, or moving within a range (a.k.a sideways or whipsaw markets).

This means that if you enter a position that is aligned with the market’s trend, for e.g. going long in a bull market, the probability of your trade making money is much higher than if you do not.

Consequently, going long in a market that is trending up will see your position generate profits relatively quickly, and can be construed as a signal that more profits are possible. 

On the other hand, if you were to enter a position opposite to the trend, for instance going short in a bull market, there is a high probability that your trade will end up with a loss.

Trades which quickly fall into the red can be thought of as a sign that the position isn’t aligned with how the market is trending, and that heavier losses are a possibility.

However, these signals aren’t as effective when a market is trading in a range, simply because when a market is range bound, profits can quickly turn into losses, and vice versa.

Therefore, if you are trading with the trend, the market will quickly give you feedback on whether or not the trade will work out in the near future.

As such, the best way to sidestep the disposition effect is to do what the market is telling you to do: stay in profitable positions, and exit unprofitable ones.

It is important to note that trading according to a market’s trend is not a substitute for rigorous risk management.

Consider a scenario where you went long in a bull market, but instead of quickly reaping gains, the trade instead rapidly racks up losses. In this situation, it is possible that you entered at an inopportune time; just before a correction, or just before the market topped out.

Since market timing is unpredictable at best, stop losses and sensible position sizing are still necessary to ensure that loss making positions do not act in concert with your cognitive biases to wipe out your trading account.

That being said, how can we allow our winners to run to their full potential while still effectively managing risk?

To be concluded…

5. Trading To Avoid The Disposition Effect

An effective method is to let the market take you out of a position, instead of having a fixed price target before entering the trade. This naturally allows for winning positions to keep on accruing profits as the market trends.

The problem with doing this, however, is that traders do not know when to exit.

This creates two problems: the first of which is figuring out when to exit a trade, and the second, figuring out how to calculate reward/risk ratios.

The first problem is easily solved by using a trailing stop. This is simply a stop loss that moves with the market, which means that if you are long and the market moves higher, the stop loss moves higher as well.

How far away to set the trailing stop is up to the individual trader, but needs to be aligned with your overall risk management strategy.

That is, if you are comfortable risking 1% of your capital on a position when using a normal (non-trailing) stop loss, your trailing stops should also be set to a level that reflects the same amount of risk.

Using our initial AAPL example, where our hypothetical trader goes long the stock at $145, let’s consider what happens if he decides to set a trailing stop.

He first decides to set his trailing stop $2 below his entry point, which is $143.

In addition, he wants to manage his trailing stop manually (some brokers can do it automatically for you), and decides to do this by updating the stop loss level near the end of each trading day by subtracting $2 from the day’s high.

If the market is trading below the level of the new stop, he would exit the position, and if the market does not make new highs, the trailing stop remains the same as the previous day’s.

Here’s how it would look:

The trailing stop does exactly what it was designed to do, allowing our AAPL trader to let his winning position run higher as Apple moves up to form a short term high at $149.82 on 26 July.

As the stock turns down the next day, the trailing stop gets him out of the position with a profit of $2.82 a share (147.82 – 145).

He has successfully allowed a winning trade to run, and cut possible future losses short when the market turned against him.

Do note that there are more sophisticated methods of calculating trailing stops, a popular variant of which is the Average True Range (ATR) stop, which factors in market volatility into the calculation of the stop loss level.

(If you are interested in learning how to construct and use an ATR stop, we discuss how to do so in our course on how to create an effective trading plan, available for free!)

This can prove useful when entering positions during times of high market volatility, where a simple “$2 below entry” rule will not provide a position the space it needs.

Now, how do we calculate our reward/risk ratios when using trailing stops?

Since trailing stops leave us without predefined exit levels, we will have to make do with less precision. The “risk” part of the ratio is straightforward since we can just use our initial stop loss level; in the AAPL example above, that would be $143.

For the “reward” portion, we can refer to the previous high (or low for shorts) on the chart and use that level. For our hypothetical AAPL trade, that high would be $149.98, set on 15 July, giving us a reward/risk of (149.98 – 145) / (145 – 143) = 2.49.

It is important to understand that calculating the “reward” portion of the ratio in this manner works because we are deliberately trading with the trend.

Therefore, selecting previous highs in a market that is trending upwards represents a reasonable compromise, since it is probable that those highs will be surpassed in the near future.

6. Recency bias

True to its name, the recency bias is the human tendency to view recent events as more significant, and therefore having more weight on today’s decision making, than events which occurred further in the past.

How can this negatively affect traders?

Consider a trader who has had the best six months of her trading career. All her trades over that period of time were profitable, her account balance is up by a substantial amount, and her confidence is sky high.

Why wouldn’t it be? 

However, she is very cognizant of the fact that the sun doesn’t shine forever, and isn’t surprised when her winning streak ends with her first loss in half a year. She shrugs it off and actually feels more relieved than upset, since she no longer feels the weight of her six month winning streak on her shoulders.

Unfortunately, that first loss turns into a second, and a third, and by the end of the seventh month, her trading account is in a sizable drawdown.

Not sizable enough for the profits from her winning streak to be erased, but large enough for it to hurt.

At this point, she begins to doubt herself. What exactly is going on?

How did she go from feeling invincible at the start of the month to flailing around for answers at the end of it? Was the six month streak a pure fluke?

Is her trading plan as sound as she thought it was when all it seemed to do was churn out profits? More worryingly, if her trading plan isn’t as sound as she thought it was, what went wrong with it?

What does she have to change?

If left unchecked, these doubts can grow to become more harmful.

For example, our trader could start to question her own ability, and seriously start to wonder if she is “good enough”, or if she has “what it takes” to be trading the markets; perhaps causing her to abandon her efforts entirely.

These doubts are a product of her recency bias.

Recent losses hurt more than those which occurred long ago as their memory is still fresh in our minds. The psychological distress they cause, especially in a string of consecutive losses, naturally casts shadows of doubt in our minds.

This ultimately prevents us from seeing reality in a clear and objective way, which also reduces our ability to make sound trading decisions.

To be continued…