The Instincts of a Successful Trader

by Rich Hamilton
March 15th, 2008

Most people accept that to be successful in stock trading you need to hold rising stocks for as long as possible and sell losers quickly. This is summed up in the trading maxim:

“Cut your losses and let your profits run.”

If you have ever traded stocks, it’s likely you’ll have felt a strong urge to do the opposite. Most likely you’ll have wanted to:

• Sell your winners quickly – using a justification such as: “I want to lock in my profits”.
• Hang on grimly to your losers – hoping that tomorrow’s price will be higher than today’s. Usually, though, it just keeps falling.

I can write confidently about this, because I’ve been there. Several years ago, when I began trading stocks, I was in the habit of selling my winners to lock in profits (of 5 to 10%) while hanging on to losers and watching them fall by as much as 80%.

Thankfully, I weaned myself away from this sort of destructive behavior and my trading record improved dramatically. It still takes an enormous amount of resolve to sell my losers quickly though; it’s a huge fight against my instincts. I still have a strong urge to hang in there with stocks that fall, waiting for the upswing.

Making Choices – Profits and Losses

Daniel Kahnerman and Amos Tversky carried out experiments in the late 1970’s that go a long way to explain our instincts to sell our winners and hold on to our losers.

They carried out experiments in which people were questioned about their preferences. Here are two questions, similar to those asked by Kahnerman and Tversky. Try answering them yourself:

Q1. You are offered a choice between two outcomes:

A. You have an 80% percent chance of winning $4,000 with a 20% chance of winning nothing.

or

B. You have a 100% chance of winning $3,000.

Which of these would you choose? Make a choice before answering Q2.

Q2. You are offered a choice between two outcomes:

A. You have an 80% chance of losing $4,000 and a 20% chance of losing nothing.

or

B. You have a 100% chance of losing $3,000.

Which of these would you choose?

It turns out that the vast majority of people choose outcome B in question 1 and outcome A in question 2. In other words:

• When we are winning we prefer to choose certainty.
• When we are losing we prefer to gamble.

These are our basic human instincts.

If your gut instinct was to answer A to Question 1 and B to Question 2, you may have the instincts of a successful stock trader. Your instinct is to gamble when you are winning – in other words let your profits run – and to choose certainty – in the form of a definite limit on your losses – when you are losing – in other words cut your losses.

After carrying out a number of experiments, Kahnerman and Tversky concluded that people are naturally averse to losing and are more willing to gamble their way out of a losing position than to gamble in a winning position:

“It’s not so much that people hate uncertainty – but rather they hate losing.”

And it’s this natural hatred of losing that destroys most beginning traders. Trading success comes when we accept losses as a natural outcome of our endeavors and take action to make sure all our losses are small losses. This allows us to profit mightily from our victories, when we are courageous enough to grow them into large victories.