Introduction
Capital management is crucial in trading. It can be said that correctly predicting market trends is only half of the battle in trading. Without a proper capital management strategy, success often slips away. Many traders adhere to the principle of “limited losses, unlimited gains,” but in practice, their approach to managing positions’ profits and losses differs significantly: taking profits is always easy, while cutting losses is always too hard!
1. Insights from a Psychological Experiment
Why is taking profits so easy, but cutting losses so hard? The answer lies in human psychology. To understand this issue, let’s consider a commonly used psychological experiment. Imagine you are asked to answer the following question:
600 people are infected with a deadly disease, and there are two drugs to choose from:
(A) Can save 200 people’s lives.
(B) Has a 1/3 chance of curing everyone and a 2/3 chance of saving no one.
Which one would you choose?
Choosing A ensures you can save 200 people, while choosing B is a gamble on how many can be saved. Therefore, the choice is simple: 72% of respondents choose A because they do not want to gamble on how many people they can save.
Now consider another question:
600 people are infected with a deadly disease, and there are two drugs to choose from:
(A) Will definitely cause 400 people to die.
(B) Has a 1/3 chance of curing everyone and a 2/3 chance of saving no one.
Would you choose to kill 400 people? Probably not, as there is still a chance to save everyone. In this scenario, only 22% of people choose A.
This interesting experiment, first designed by Kahneman and Tversky in 1981, actually presents the same problem framed differently. The first focuses on gains, while the second focuses on losses. These scientists concluded from this and similar questions that people have different attitudes towards gains and losses: people are more willing to gamble on losses rather than on gains.
Let’s see how this conclusion applies to the market. Gains and losses are common in investing. Suppose you hold a position that has already incurred losses. What will you do? You will likely bet, like most people, that it will eventually “come back” (i.e., the paper loss will turn into a gain or the loss will reduce). Now suppose your position has already made a profit. This time, you won’t gamble. Your approach is simple: take the profit immediately and lock it in. This phenomenon of “taking profits is easy, cutting losses is hard” violates the principle of “limited losses, unlimited gains.” Over time, many investors’ accounts shrink, and more frighteningly, due to a few significant losses that can’t be recovered, their funds are almost depleted.
2. Prospect Theory Explains “Cutting Losses Is Hard”
Prospect theory, proposed by Kahneman and Tversky in 1979, explains why traders are more willing to take profits rather than cut losses:
Prospect Theory: For gains and losses of the same magnitude, people feel losses more intensely. This explains why traders are more inclined to hold losing positions, hoping the market will reverse, rather than accepting the loss.
3. Regret Theory Explains “Cutting Losses Is Hard”
Further, psychologists believe that “regret theory” can partly explain this phenomenon. Statman, an authority on regret theory, pointed out an obvious fact (refer to his 1994 paper “Tracking Error, Regret, and Asset Allocation Strategies”). According to Statman, we prefer to gamble on losses because we don’t want to face the reality of failure. Applying this theory to the market, we can imagine that by holding onto a losing position (hoping it will come back), we don’t have to admit we made a mistake. After all, as long as the position hasn’t been closed, the loss is just on paper. Can you say I’ve lost? In this case, most people prefer to believe that something will happen to reverse the market direction, so they tend to stop trading and do nothing when holding a losing position.
In 1985, Shefrin and Statman explained why people are reluctant to cut losses, using the stock market as an example. Let’s borrow their explanation for the market. In general, people trade for cognitive and emotional reasons. They trade because they believe they have information, but in reality, they only have noise. They trade forex, stocks, futures, and cryptocurrencies because trading gives them pride. When the decision is correct, trading brings pride; when the decision is wrong, trading brings regret. Investors want to avoid the pain of regret, so they hold onto losing positions to avoid realizing the loss.
Regret theory, also known as “risk aversion,” is a typical example of a self-protective attitude and explains why investors find it hard to cut losses.
Another phenomenon that explains prospect theory is “mental accounting.” The basic reasoning is that we like to categorize unknown quantities and treat them differently rather than considering them as a whole. A typical symptom of this phenomenon is holding onto losing positions, making it difficult to invest in other more promising assets due to capital constraints. We always try to optimize each investment (a foolish approach), even if we know it means missing out on overall investment opportunities. I once witnessed a client who held onto losing wheat contracts for more than three months, eventually having to close them at a loss. During this time, due to capital constraints and frustration, he missed out on several trading opportunities that he had accurately identified.
Cognitive dissonance can ultimately explain why cutting losses is so hard. Closing a losing position means admitting that our market view and the harsh reality of the market are inconsistent.
4. Why “Taking Profits Is Easy”
When the market moves in the direction the trader predicted, the position starts to show a profit, and the situation is entirely different: winners have nothing to hide. However, winners face another trap: they prefer to attribute their success to personal effort rather than luck. Social psychologists call this phenomenon “overconfidence.” On average, we are all overconfident. Most people believe that their personal qualities and abilities are above average – including driving skills, sense of humor, risk control ability, and life expectancy. For example, when a group of American students was asked about their driving safety skills, 82% believed they were in the top 30%. What does this mean for investors making money in the market? This theory suggests that many investors attribute their recent profits in the market to their superior investment skills. And because they believe they are highly skilled, they trade more frequently, with some even trying to capture every market fluctuation. Therefore, their enthusiasm for taking profits is mainly driven by personal confidence.
5. Conclusion
Many investors struggle with the dilemma of “taking profits is easy, cutting losses is hard,” which is actually a human weakness. To conquer the market, one must first conquer oneself. Gains and losses are common in investing. To achieve long-term profitability in the market, one must correctly view both gains and losses. This is the prerequisite for establishing a scientific capital management strategy. Before trading, develop a detailed trading plan and then strictly execute it. Don’t take profits casually if you shouldn’t, and don’t hesitate to cut losses when necessary.
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