Long Live Sloth

We all know about Loss Aversion. Faced with a choice between a sure gain of Rs 100 and a toss of a (fair) coin which can increase the gain to Rs 200 or bring it down to zero, most people would choose to go with the first option that is retain the Rs 100. When the choice is between a sure loss of Rs 100 and a toss of a coin which can reduce the loss to zero or increase it to Rs 200, most people would choose to toss the coin. The point is most people will avoid taking risk which could reduce a profit but would take the same risk to avoid making a loss even if it means taking a larger loss in the process.

This effect is seen in the investment world too when an investment that is making a loss is held on in the hope of reducing the loss whereas a profitable investment is sold to ensure that the profits do not evaporate.

Now, any trader worth his salt knows that this is a sure way to ensure that his results are at best sub optimal and at worst loss making. Trend following for eg. involves the ability to give up a lot of the MTM profits to ensure that a higher profit is made. It also involves taking small losses regularly in order to profit from that one large trended move. This goes completely against the grain of normal human behavior as we have just discussed. Just knowing about this, however, is not enough to prevent this bias from working its magic on the trader. After all, this drive, this bias, works at the subconscious level and to work around it requires a lot of self control and discipline. The question is whether there is anything that can be done to help mitigate the effects of this bias and to strengthen the traders resolve.

My solution typically revolves around my MIS. Suppose I already have a booked profit for the year of 50lacs (wishful thinking but I can always indulge in it) and I buy 10000 nifty futures at 5000. Suppose I also know that my system will require me to sell it if Nifty touches 4900 that is a loss of 100 points, then my MIS will look like this.

           Booked Profit/loss   50  lacs

Minus  Potential Loss         10  lacs

Total    Profit/loss                40 lacs

Even when the trade starts becoming profitable I do not include the MTM profits in my MIS. If the Nifty goes to 5200 and I am Rs 20 lacs in the money, I do not want to see it in my MIS. The MIS remains the same as it was on Day1. The Nifty might drift lower to 5100 and I will still not worry about the MTM profit fall from Rs 20 lacs to Rs 10 lacs because I do not see it in the MIS. If I had shown the Rs 20 lacs MTM profit in my MIS I would have already been counting on that profit and would have been wanting to protect it. Only after I finally get out of my trade say at 5500 (again wishful thinking) and book a Rs 50 lac profit will the actual profit or loss be changed to Rs 1 crore and the potential loss be reset to zero.

The main idea is that the potential loss on the trade is reduced from the booked profit loss from day 1 of the trade. This way, after the initial pain of seeing the booked profit reduce, I do not have to see a change in my profit/loss statement on a daily basis and thus the powerful Loss aversion bias does not hold its sway on me. This helps me to sell my trade at a loss when it hits my stoploss levels without having to wait and hope for the loss to reduce. Similarly, I am willing to let the profits run because I do not show the MTM profits in my MTM and try to be consciously unaware of the unbooked profits in my trade.

While, it looks like a good idea and worth emulating, people who know me will question whether there is more to it than meets the eye. They will notice that this method requires me to make no changes to the MIS for all the days that I am in the trade. They will notice that doing nothing is my favorite passtime. They will then come to the conclusion that this idea must have struck me because of my inherent sloth and laziness. For the third day in a row my weakness has become my strength and helps me beat normal human biases! I guess very soon I will have to stop calling laziness as a weakness.

After talking about profits and losses I have to admit that I am short on the Nifty from 5045 levels and will cut the short positions and go long above 5175.