I think it is important to touch on this subject. Personally, I believe that 99% of trading is psychological and only 1% is actual trading itself. So it should come as no surprise that I think we should focus a great deal on our thoughts, habits, and beliefs when it comes to trading. It is through knowing ourselves (how we behave, how we react to stress, our deepest desires, and our greed) that we can place barriers in our minds and create rules around our trading to keep ourselves from making wrong decisions. Our heart is most deceitful – it lies to us, tempts us, dangles the carrot in front of us; who can truly know the heart? One of the lies our heart will tell us is a four-letter trading epithet: hope.
I’ve experienced this myself firsthand on more than one occasion: when a trade goes against me, I say to myself, “Not this time. It’s about to reverse. There is hope.” It is during this moment that I realise that there really is no hope – the price will not reverse but I am far too invested in the position to let it go and take a loss. But grasping onto hope, I stubbornly hold on for a while longer until the pain of the looming loss is too much to bear. By then, I have no choice and I take the loss. Naturally, a few weeks later, price reverses. But if I had taken the loss early on, I could’ve hitched a ride with the trend, made back what would’ve been a much smaller loss, and when price reverses, make a profit. This experience is tried and true. People have argued with me on this until they were blue in the face. But at the end of the day, given enough opportunities (if they can survive the pain long enough before the margin call), the market proves me right. Any trend that goes against a losing trade can go on for much longer than anyone ever anticipates. As soon as you think price will reverse, it throws a wrench into your prediction and marches forward with renewed vigour. Even if price reverses, oftentimes it does not reverse enough.
Recently, I suggested to someone not to average down their loss. Instead of listening to me, he proceeded to do just that and went on to tell me how his strategy works in an all-out Twitter-debate. It’s as if he’s the only who has ever done this! So I asked him a simple question: how long did it take for his previous average-downs to either break-even or profit? The answer? Years. But he’s fortunate! Most people don’t break-even, let alone make a profit. Rather, the loss continues until there is no point to let go of the shares. For every exception, a thousand others have failed miserably. If you find yourself in a position where the only reason you’re holding on is because you’re far too invested in the loss or if you’re thinking of adding to the loss (averaging down) or if you’re letting go of the loss but thinking of hedging the loss just in case the market reverses, then you need to stop, take a deep breath, and reflect on your emotions and thoughts. You are trading based on hope.
I think Jesse Livermore, one of the 20th century’s greatest traders, describes this concept best in his book, How to Trade in the Stock Market (1940). I quoted the relevant excerpt from chapter 4 below:
Blunders by incompetent speculators cover a wide scale. I have warned against averaging losses. That is a most common practice. Great numbers of people will buy a stock, let us say at 50, and two or three days later if they can buy it at 47 they are seized with the urge to average down by buying another hundred shares, making an average price of 48 on all.
Having bought at 50 and being concerned over a three-point loss on a hundred shares, what rhyme or reason is there in adding another hundred shares and having the double worry when the price hits 44? At that point there would be a $600 loss on the first hundred shares and a $300 loss on the second hundred shares.
If one is to apply such an unsound principle, he should keep on averaging by buying two hundred shares at 44, then four hundred at 41, eight hundred at 38, sixteen hundred at 35, thirty-two hundred at 32, sixty-four hundred at 29 and so on. How many speculators could stand such pressure? Yet if the policy is sound it should not be abandoned. Of course abnormal moves such as the one indicated do not happen often. But it is just such abnormal moves against which the speculator must guard to avoid disaster.
So at the risk of repetition and preaching, let me urge you to avoid averaging down. I know but one sure tip I got from a broker. It is your “Margin Call – When the margin call reaches you, close your account – never meet a margin call.” You are on the wrong side of the market. Why send good money after bad? Keep that good money for another day. Risk it on something more attractive than an obviously losing deal.
And yet, 77 years later, people are still doing this exact thing to their own detriment.