How does one integrate losses into a successful trading strategy? A logical and disciplined handling of "loss psychology" is important in order to turn negative experiences into positive ones. In this article, we'll identify the common traps that arise when emotional commitment and psychological reactions get in the way of investing.

Learning From Losses
It is no secret that losses are part of trading, but this does not make them easy to take or deal with. Emotional commitment and a lack of discipline should not be a part of trading; despite this, they play a key decision-making role for many investors and many traders suffer from negative psychological effects that impact their behavior.

For this reason, every investor must know how to handle negative experiences. The golden rule is to differentiate between those based on rational and prudent trading strategies on the one hand and emotionally-based, panicky decisions on the other. The former generally leads to success over time, while the latter tends to lead to failure.

Can traders really break free from their fear of financial losses? Absolutely, but doing this successfully requires looking at what has happened logically and from a conscious psychological perspective so you can act accordingly. Losses can have a value, but only if you take the time to learn and understand that some losses are simply inevitable, and undertake "loss management" to deal with them, rather than letting them get out of control. (For further reading, see Trading Psychology And Discipline.)

Loss Through Paralysis
The most commonly observed symptom of bad loss management is deterioration in discipline and an inability to exploit the prevailing trading opportunities at the time. This can mean being frozen into total inactivity. Losses that are disastrous are likely to stun the investor so that he sits on them, trying to rationalize leaving things as they are. This can happen when a trader becomes complacent and believes that he or she knows the investment will have a positive outcome.

In this state, if the market situation changes radically for the worse and leads to significant losses, the trader will be shocked. This can trigger a spiral of irrational decisions. For instance, stop-loss criteria may become too tight as the trader recoils in horror from further potential losses. Fear and a loss of self confidence may also further prevent the trader from acting sensibly, or, as explained earlier, acting at all.

Ego Losses
Oftentimes, a dealer with a fair amount of money or who has done reasonably well for some time may start to overestimate either his own abilities or what can realistically be achieved in the markets. After a lengthy and profitable period, something suddenly goes wrong.

In the worst-case scenario, the trader plunges frantically into anything that looks profitable, no matter what the risks, and then desperately leaps out again at any hint of a downturn. For many an intrepid investor, this spiral ends only when the money runs out.

As a result, what often starts as a placid venture into equities and bonds, develops into a tempestuous ride through options, futures and equities in the most obscure places and markets, where booms and busts are the order of the day. The trader therefore becomes more risk friendly; there can even be a complete change in trading style and strategy. This change is not driven by rational decision-making, but by desperation and despair. Such traders may be seen driving a Rolls Royce one month and catching a bus the next. (For related reading, see Choose Your Own Asset Allocation Adventure.)

Losses As Part of Strategy
All good traders have the ability to formulate and apply a strategy without getting caught up in their own emotions. This includes the ability to handle losses in a positive and sensible manner. The right approach entails accepting the inevitability of losses, limiting them and understanding your own mentality and psychology. In many instances, losses need to be seen for what they are - an indicator that a strategic change is required. They may also be the result of natural market developments that could not have been predicted earlier. Therefore, a portfolio that becomes imbalanced needs to be restructured coolly and dispassionately. (For more insight, read Are You A Disciplined Investor?)

The situation must be handled with logic and discipline. "Emotional neutrality" may be the core concept. The presence of losses requires analysis to determine the cause. If the asset allocation is right in the first place, it may be sufficient to simply ride out the storm. If the balance is wrong, this needs to be adjusted to maintain an appropriate level of risk.

The main errors in trading are:

  • Attempting to win back losses by taking on more risk than you can afford or are comfortable with
  • Taking on so little risk that you cannot possibly make any money in the long run

In short, if you were doing something wrong, get it right. Alternatively, if the markets were simply adverse, react to them as you would advise a third party to do. Do not let your emotions take control. Do only to yourself what you would advise others to do. (To learn more about risk tolerance, read Personalizing Risk Tolerance.)

Avoiding Real Blunders Is Also Fundamental
Of course, some losses should not occur. Risk profiles must be adhered to from start to finish, and the money must be well managed in general. The up-front, proactive part of handling losses entails avoiding bad investment decisions in the first place.

Provided your investments make sense in the first place and are well managed, losses are simply inevitable to some degree and in some situations. It is necessary to take them in stride and react prudently, dispassionately and strategically. Either let the relevant markets right themselves over time, as they often do, or rebalance and restructure according to the well-proven principles of asset allocation and fund management.

For insight on how to overcome mental hurdles when trading, read Master Your Trading Mindtraps.