Another moment in your investing operations to be extra careful

The break-even effect makes you drool

Hi,

I can’t remember if I have written much about cutting losses in my letters yet. In case not, it is one of the most important decision making skills to learn in investing and life.

In short, when you realise you are losing, take and accept the loss before it compounds to something greater and even more painful.

Today instead, I want to get your attention on a cognitive bias called the break-even effect. It happens right after you have taken a loss consciously.

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The key to understanding our biases is that our brain will always try to drive us away from pain towards gain, comfort and pleasure.

So what happens right after we take a loss?

Auch. Let’s imagine losing 20% on an investment/bet we were sure was going to the moon. That sucked big time.

Worse, we decided to materialise the loss so that we can put the money to work elsewhere and have a positive investment performance on our portfolio.

This is actually the correct approach, it just feels bad. The situation is not worse, it is better, but our feelings are worse.

Short note: keep in mind that to recoup a 20% loss on the same amount of money we need to profit 25%. 50% if we lost 33%. If your position got halved to a 50% loss, you need a very difficult 100% gain afterwards only to break even!

Back to our scenario.

Cutting the loss at 20% was a good choice. The taste though is not good. It’s a loss. Some of us might even go as far as doubting our investing skills and tell ourselves we suck.

Now some pleasure to escape this bad feeling would be good, right?

Let’s go find a better investment! Yes, there are always a lot of opportunities, let’s find one with high potential to earn way more than 25%! This way it will be as if we didn’t lose in the first place!

And we have turned into a drooling animal hunting for prey.

What is the chance of us thinking rationally about our next investment and not leaning towards taking higher risk? Low chance.

This is the break-even effect, studied by Richard Thaler and Eric Johnson in a paper titled “Gambling with the House Money and Trying to Break Even: The Effects of Prior Outcomes on Risky Choice”.

The research paper states that in the presence of prior losses, outcomes which offer a chance to break even are especially attractive.

In other words, we will invest riskier than we would normally, increasing our chances of losing instead of actually recouping.

So how do we control ourselves and behave more rationally?

• Be extra careful after you materialise a loss and are looking to deploy the money elsewhere
• When you make an investment decision, forget any past performance of yours on the asset and always ask yourself “if this was the first time I ever looked at this asset with the current data I have available, would I invest?”
• Realize that keeping some cash at hand instead of deploying it all will make sure you have options and possibilities to jump on future better opportunities.

Related to drooling, don’t invest when you are hungry, have a snack before your investing routine. Personal experience, no scientific research done (yet).

Have a good one,

Chris

Originally posted 29th January 2023 on ElliottSays.com

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