“Even a small loss evokes a sense of frustration. There’s something magical about ‘at least breaking even’.”
– David Laibson, Behaviorial Economist, quoted in “Be It Ever So Illogical: Homeowners Who Won’t Cut the Price” , The New York Times, March 26
Read any trading book or advice from legendary traders and you’ll hear the same thing over and over again: The #1 rule is Cut Your Losses.
This is tantamount to: own up to mistakes quickly.
The reason is that when we’ve made a mistake and a position rightly moves against us, it is likely that it will continue to move against us. The best course of action is to figure out that we got it wrong and get out – quick. That way you minimize the damage i.e. cut your losses.
But, interestingly, for psychological reasons, this tends to be one of the hardest things to do. We at least want to hang on until we bet back to breakeven. For reasons of ego or hope or frustration, it is hard for us human beings to admit to making a mistake and/or to take a loss.
One attribute of great traders is their ability to separate their egos and emotions from what is going on, be flexible, and make decisions based upon the available and evolving information.
One of the things going on in the housing market right now is that homeowners are unwilling to face up to the current reality and cut prices. They are unwilling to admit that they made a bad investment and/or to take a loss – even though doing so now could be the most rational course of action as prices are likely to head even lower over the next 12 to 18 months.
This is resulting in a massive inventory of unsold homes and essentially a standstill in the housing market with sales volumes falling off a cliff.
Ultimately, many of these people will be forced to sell or give in further down the line, at lower prices. But the psychological difficulty of taking a loss will cost them.
Learn to admit mistakes, be humble, be open, be flexible and, it can’t be said often enough, Cut Your Losses When You’ve Made A Mistake.