Why investors lose money
Do you know that private investors are more likely to suffer big losses than other market participants?
1
They trade with emotions
Kahneman and Trevsky (professors of psychology that won the Nobel prize in Economics 2002) showed that investors clouded by emotions are simply not taking rational decisions when facing risk. Say you have two investments, one gaining $50 and one losing $50. What Kahneman says is that for the loss of $50 you feel pain dis proportionally bigger to the level of joy from the equivalent gain of $50. Due to this fact we tend to: hold to our losses and not applying stop-losses increase our positions on losing trades close the gaining positions early trading fast when making money and the opposite when losing … and plenty of others.
2
They take uneven risks
Basically we tend to invest more on investments we believe more. The problem is that our forecasting ability is significantly smaller to what we think it is and as such we size our portfolio disproportionally to our convictions which create substantial imbalances. This can lead to excessive losses, especially from the investments we believe more! As said before, timing is not everything, sizing is!
3
They value their trade decisions in a binary way (not probabilistic)
Last but not least, we typically understand and interpret the markets in binary terms; “right or wrong”, “up or down”, “black and white” It is convenient to think this way but hardly true! A more realistic approach is to see markets in a probabilistic way, thinking in terms of probabilities of a certain outcome. As Mandelbrot famously puts it, “Markets can be seen as a black box covered by a veil. They are many times unpredictable, difficult to control and “anticipation” from market participants makes things even more complicated. In the real world of fast markets, veiled motives, uncertain outcomes, probability is the only tool at our disposal”