Trading Psychology: How to Cope with Losses 

Losing money in the financial markets is a tough pill to swallow for most traders. A big loss may not only affect your bank account, but your trading psychology as a whole. However, letting your fear of losing control you virtually guarantees you’ll never become a successful trader. While pain aversion is a powerful mechanism of the human mind, it has negative consequences when applied to trading.

Traders who let their fear of losing dictate their trading strategy suffer from loss aversion, a phrase first coined and demonstrated by psychologists Amos Tversky and Daniel Kahneman.  Loss aversion is a decision theory that describes people’s fear of losing things. Most of the time, people strongly prefer avoiding losses over making gains. When money is on the line, as in the case of financial trading, this central tendency can be more powerful.

One of the first steps to becoming a successful trader is to master your trading psychology. This means coming to grips with your loss aversion. According to Tversky and Kahneman, our brain usually assigns two-and-a-half times the weight to a loss as it does to a gain. Lots of evidence suggests humans are so hardwired to avoid losing that the majority of us would even resort to gambling just to avoid a loss.[1]

Despite this unfortunate reality, there are steps you can take to minimize your fear of losing. The first step is to recognize that losses are bound to happen in financial trading. Even if you follow an effective trading strategy without deviation, you may still succumb to the laws of probability.

According to American businessman and investor Peter Lynch, “In this business if you’re good, you’re right six times out of ten. You’re never going to be right nine times out of ten.”[2]

If you suspect there’s more than just the law of probability making you lose, such as bad behaviour or poor strategy, take a break from trading altogether. This will give you time to process what happened and identify the source of your failings. This is the perfect time to refocus and refine your trading strategy.

The second step to minimizing your fear of losing is learning as much as you can about the instruments and markets you are trading. An informed trader is a more confident trader, one who is less prone to losing. This includes, but is not limited to, understanding technical and fundamental analysis, setting up an effective risk management strategy and managing your expectations. Risk management is absolutely critical to becoming a successful trader. By defining your entry and exit positions, using stop-losses and clearly defining your acceptable level of drawdown, you may be better positioned to minimize your losses almost automatically.

The third step to overcoming loss aversion is to stay motivated by constantly reminding yourself why you became a trader in the first place. Trading is a long process that, when done correctly, should yield you better results over time. One of the best remedies to loss aversion is success. By making money as a trader, you will be motivated by profit and reward rather than by fear.

Final Takeaways

For most people, loss aversion is a symptom of being human. As a trader, you must learn to minimize it as much as you can so that you can focus on making gains as opposed to avoiding losses. With a proper risk management strategy in place, you won’t have to spend all of your time thinking about loss avoidance.

There is no room for denial in the trading world.[3] Every successful trader reached the top through deliberate action and motivation, not by avoiding setbacks. By leading with reward instead of pain, you will be on your way to mastering your own psychology.

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