Psychology Articles

Why everything you’ve been taught about risk is all wrong and how it’s keeping you poor!

Wow, what a title. Not really short and punchy, but it does tell a story. The majority of people have been given a backwards view on risk which leads to the statement:

“Let your losses run and cut your profits short!”

Totally wrong I grant you but that’s what happens because we have not been properly taught about risk.

 

A Brief Look at Risk

People take risks every day, even driving to work constitutes a risk, since nearly 1.3 million people die in road crashes each year across the globe…

Staying at home with your head stuck under the covers, however, is just as big a risk. Because if you do that you are going to be 100X more likely to suffer from anxiety and depression. Which can and has led to suicide…

No matter what we do, we will be taking a risk.  The secret of taking risk successfully is to be prepared.  This requires a person to thoroughly know the risk involved. Now, understanding risk can be difficult because the topic has so many dimensions.  Trading risk is defined objectively as the variability of performance of invested funds that go up and down in value.  Now if you add to that, that each trader has a subjective concept of risk which may have little relation to the performance variability. You start to understand that subjective risk has more to do with the fear that a person attaches to a particular activity, rather than the activity itself.

 

Jumping into The Fire

Let’s take career choices as an example. Who would you say takes the bigger risk a Helicopter pilot who takes holidaymakers across a lava lake on Hawaii or a school teacher…

Lava lake risk

 

No brainer, right? The school teacher. Ha-ha only kidding it’s obviously the helicopter pilot. But what if I told you the school teacher works in a high school in Los Angeles with the highest number of gang-related incidents happening every day in school. That’s incidents every day. Also, she has to commute 25 miles on Los Angeles freeways during rush hour.

How about if I added the facts that she has been involved in two fender benders in the last five years and gets her life threatened on a regular basis, while the Helicopter pilot has had no incidents in the last 15 years…

Who do you believe is taking the bigger risk every day.

 

 

 

 

Trading Risk

Let’s say we have two traders, one trades Forex and one physically trades gold who takes the bigger risk?

What if I told you the Forex trader only risks 2% per trade with a maximum of 8 trades open at any time, while the gold trader is fully invested at all times… meaning he always has all his capital tied up in gold…

Now, who would you say is the bigger risk taker?

Did you change your mind?

People assume, for example, that Forex trading is risky because most people lose, whereas investing in gold is less risky because fewer people lose.  Obviously, the second part of that statement is debatable – gold investors may just take longer to lose.  The probability of losing in an investment instrument is just a subjective definition of risk… i.e. people tend to think that if most people lose that instrument must be risky.

The objective definition of risk, in contrast, is how much you stand to lose on a given position. And a top trader might take low-risk ideas say 1% per trade and regularly make 6 – 10% per month. If the top traders’ performance is consistently good, then he takes little risk from the objective viewpoint.

Whereas, poor traders will not search for low-risk ideas. Their performance will be erratic at best, and as a result, their account variability (the risk) will be high…

In order to trade, you must understand your risk at every stage. Including when you first place that trade be that 2% of your account or $400, you must know what it is, and you must be prepared to lose it.

 

The Loss Trap

A very powerful, hidden trap lurks within the risk process, which we’ll call the loss trap. In order to be a successful trader, you must make it OK to lose, if you want to win!

Now most of us are taught that winning is everything or the only thing. You can imagine top football coaches telling their players that they must win.  Yet when a team becomes defensive and concentrates on avoiding a loss, the team typically loses.

How about the business executive who tells employees that they must win if they want to survive?  In those situations when winning is everything, people are more likely to lose… Sound familiar? The more you try to win the more you seem to lose. I get it, I’ve been there and had that feeling…

Think of the football team that gets slaughtered in the first half and then comes out a completely different side for the second. Before halftime, they were fearful of losing, so they were likely to lose. In the second half, they had already taken the loss in their heads so there was nothing to lose. And when it’s OK to lose, the team could perform at a peak level. Which gives them every chance to win.

 

Chinese Finger Trap

Taking losses goes against our cultural training. The loser is not respected, let’s face it no one remembers who got silver.  The loser feels as if he or she is somehow inferior.  Yet if there is one secret to becoming a winning trader, it’s to make it OK to lose.  You are playing a game and losing is part of that game.        Chinese finger trap risk

Now, the loss trap is similar to a toy that I used to play with as a kid – the Chinese finger trap. It’s a four-inch woven straw cylinder with a hole at each end just big enough for your small finger.  Once you insert your finger you are in the trap. The harder you pull to try and get out, the tighter the cylinder gets around your fingers.  Only when you let go and relax does the trap let go of you.

Similarly, the more a trader resists a loss, the tighter the loss trap becomes. Hidden factors are keeping you deep in the jaws of the trap as you struggle with the loss. The more you try and resist the loss, the more difficult it is to get away from those losses…

“It’s very difficult to trade if you’re not willing to lose. Almost impossible.  It’s like wanting to be alive, always willing to breathe in, but not willing to breathe out.”

If you can make it OK to lose and take little losses, you can compensate for those losses with big wins. But if you find it unacceptable and you won’t take losses when you should, you will find that the small loss becomes much bigger. And a big loss is a disaster, that is very hard to recover from.

If you want to be a losing trader follow this simple rule…  Hang on to your losses and watch them grow!

 

Framing Risk

Each situation in life may be viewed from a number of different perspectives, each producing a different way of perceiving a situation. This is called framing as each situation is viewed with a different frame or viewpoint.  Let me illustrate framing by telling you the story of the farmer who could not accept the frames that his neighbors held:

 

An old farmer was considered to be well off by his neighbors because he had a horse, a plow, and a strong son.

But one day the horse ran off. All the neighbors came to visit and exclaim how unlucky the farmer was. The farmer just said maybe.

Three days later the horse returned, bringing with him two wild horses. The neighbors rejoiced at how lucky the farmer was, but he just said maybe.

During the next week, when the farmer’s son was trying to tame one of the wild horses, he fell off and broke his leg. The neighbors all exclaimed how unlucky the farmer was, but he just said maybe.

That weekend the soldiers came to the village to recruit young men for military duty. When they saw the farmer’s son with his broken leg, they rejected him. The neighbors knew that the farmer was lucky, but he just said, Maybe…

 

This story just illustrates that the most widely held frame, the one usually held by your peers, is not necessarily the correct one. Some common frames can be disastrous for you as a trader. These are the frames that support the loss trap:

 

The Loss Is Not A Loss Frame

Many money decisions involve a loss that is framed as something else, making it seem less painful or even acceptable. A $600 insurance premium is a sure loss, but most of us don’t consider it as such. You might even argue that it is not a sure loss compared with a $10,000 accident bill that you may receive.

But that argument really just supports the frame. The insurance company may pay your bill off, but you won’t get your $600 back. You have just limited your loss to $600 and that is still a sure loss. I’m not saying avoid paying your insurance, just understand that it is a sure loss. And insurance is a prime example of the loss is not a loss frame.

Picture the retailer who features cash discount in their advert.  Would you be as attracted to the same deal if the company stated, if you pay cash you avoid our 4% credit card surcharge? The two are the same, just framed differently. One sounds more appealing than the other.

So, how does it apply to trading. Consider this following decision and answer with what best describes your feelings…

Would you find a $200 expense acceptable if it gave you a 60% chance to win $350 and a 40% chance of no gain?  Do you feel that this is an acceptable risk?

What about…

Would you take a risk that gave you a 60% chance to win$150 and a 40% chance to lose $200? Is this an acceptable risk?

Now, which decision did you find more acceptable?

You may have decided that decision one was a more acceptable risk. After all, you could win $350, and you would not lose anything except your expenses. Decision one is commonly made by traders.  How did you feel about decision two?  Perhaps it did not seem as good. You only had a chance to win $150, and you could lose even more. Losing more than you can win is not that acceptable. So, if you’re like most traders you will find decision one more acceptable than decision two.

But if you look closely at the two decisions you can see that they are mathematically the same. The apparent difference is that the loss is framed as an expense in decision one, while it is framed as a loss in decision two.  When the $200 in expenses is considered as a loss – and it is a loss – the $350 gain becomes $150 gain and no gain becomes a $200 loss. If you realized that they were both equivalent, congrats. Hopefully, you are just as perceptive when real money is at stake.

 

The Percentage Frame

Framing is also important with respect to the cost of an item. Many people will drive across town to save $5 on a purchase of a $20 article of clothing. They, however, wouldn’t dream of driving across town to save $5 on the cost of a $500 appliance. Yet the saving is exactly the same, and the cost of driving across town, which is probably more than the $5 savings, is exactly the same.  Somehow the added miles and time seem worth a 25% savings, but they are not worth the 1% savings, even though both savings are $5. As a result, high ticket items have a lot of pricing variability between stores because people are much more concerned with the percent saved than with the actual dollar amount. This is the percentage frame.

The percentage frame is important to traders.

You’re more likely to tolerate a $500 loss on a $10,000 account which is 5% than a $500 loss on a $2,000 account which is 25%. Before swap costs are figured into each loss, the two losses are equivalent!  They won’t be the same R multiples, but the dollar amount is the same. One you can tolerate one you can’t.

The loser with large losses can use the percentage frame to turn his losses into a catastrophe. For example, consider someone who has a 5k loss that appears to have bottomed out. He is quite willing to risk a few hundred dollars more, which he perceives as his maximum risk because he believes it is at the bottom, in order to recover his money.  This small risk seems even more attractive and the bottom seems even closer because the percentage frame becomes more effective. The percentage frame as a rule just allows losses to grow.

All types of traders apply the percentage frame to their trading strategy. They do so by failing to see a losing strategy as a losing strategy. A trader may have lost $100,000 over three years, leaving only an emergency fund of 5k. When the 5k is framed against the 100k it seems poultry. As a result, the trader is willing to risk his last 5k in a desperate attempt to make back his losses. Even this act of desperation may not end the loss trap, as some traders go heavily into debt before they finally let go…

 

The Criterion Frame

You may have noticed on your journey that there are traders who change their trading criteria as a result of losing. This may even be you…

People get into the loss trap, only to forget their original goals.  Suddenly, the trader’s goal is just to recoup losses. He reasons that he is not asking fate for much – just to make back what he gave away. That paltry goal, however, may amount to a return of 2,000% on his remaining capital. The trader may become desperate and irrational because the goal Is unattainable.  A trading criterion is a framework for behavior, and as the criterion changes, so does the behavior.

What kind of criterion do you have for selecting a trade?

Intrinsic value

A high probability of winning

A large payoff

Low probability of losing

Limited total loss

Do you apply one or more of these criteria on a planned and regular basis to your trades?  Are you definite about which criteria you use? Perhaps you had not considered that the five items above were different criteria?

 

Understanding Risk

So, I’ve shown you how risk is subjective, and it depends upon your perspective.

In order for you to address your fear of a loss, you have to start changing your perspective on the loss. See it as a calculated risk, a cost of playing the game of trading. And start to understand that risk is a part of life and not to be feared.

I also told you about the loss trap and how it works, this time it is your fear keeping you in a trade you should have closed a long time ago. The only way to combat this is to have a plan and know the risk before placing a trade by having a stop loss.  And never move your stop loss against yourself.

The loss is not a loss frame

Start recognising losses for what they are. When you start to see and understand that you are taking losses throughout your life on a regular basis and it’s not killing you, your subconscious will stop thinking that losses are that dangerous. And this will help to ease your fear of a loss.

The Percentage Frame

Start to see the percentage frame for what it is. Next time you or your partner get hooked by a so-called deal. Have a look and see what the underlying deal Is or isn’t. This just reinforces the belief that losses are everywhere and are a natural part of the game of life as well as trading. Again, this will help ease your fear of a loss.

The criterion frame

This one was more for understanding so that you can prevent yourself from changing your criteria through loss. Whatever your plan is don’t change it after a loss. You should have a review date for your system and your trades, and only make changes at this time. This will stop you from making decisions through emotion rather than logic.

 

If you like what you have read, and think you may want our help please don’t hesitate to contact me:

callum@specialfxacademy.com

Or visit our Facebook Page

https://www.facebook.com/sfxacademy/

And ask any questions you have there.

If you would like any information on our Trader Accelerator Program please click here.

Or maybe you would just like to watch a trader in action, if this is you. Click here.

 

To Your Trading Success

 

Callum


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Callum McLean

Co-Founder and Trading Psychologist at Special FX Academy
Trading Psychology Coach and Certified NLP Coach. It is my belief that trading is 99% Psychological. And it is by understanding and improving your psychology, that you can be a successful trader. Success is a formula that everyone can and should learn.
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