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#1 04-03-2020 11:11:08

Admin & Trader
From: Paris - France
Registered: 21-12-2009
Posts: 3176

An analysis of trading psychology and the sunk cost concept

An analysis of trading psychology and the sunk cost concept

Being able to change your mind is the most underrated trading skill of all.

Adapting, turning, changing course and modifying your strategy halfway through a trade are all qualities that can prove useful to traders. Being able to maneuver in the face of new information is an art, a powerful tool that can save you both time and money.

It sounds simple. When things go wrong, the market behaves irrationally and your initial strategy goes wrong, you recover, adjust and adjust your strategy based on the new data.

If only the human brain worked this way.

Unfortunately, people tend to stick to their ideas and keep going the same way, even when things don't go as planned. This phenomenon doesn't only apply to trading, but it is a trend that is found in all areas of life.

The sunk cost concept

Think of all the times you insisted that your friendship or your romantic relationship work. The time and effort you put into trying to fix something that was broken. The signs came in all forms and frequencies, but you chose to look elsewhere: fights, arguments, disagreements, nights when you felt miserable.

The growing negative feelings of engaging in this choice should have made you change your mind and freed you, but the more things went wrong, the more you seemed to hold on to life.

If this example doesn't tell you anything, maybe this one will remind you of something. You go out with your friends, and they order a bottle of whisky. The cost will be split equally between all 3 of you, regardless of the consumption of each. Even if you don't want to drink, you force yourself to do it just because you paid a share of the whisky.

Still not convinced? What about this New Years resolution? The pottery class you hated from the first minute you put your fingers on wet clay, but kept on doing it because it was what you promised you would do. You were stuck with an experience that you clearly knew had no value to you, but for one reason or another, you didn't have the mental strength to unplug it and move on.

This pattern of behavior has a name, and it is called the sunk cost trap or the escalation of engagement. This phenomenon is linked to the inability of human beings to make rational decisions based on the events that occur before their eyes. The main drivers of this behaviour are the ego and the need to prove that you didn't waste your time or your money, which brings us back to trading.

Logic dictates that by making trading decisions, the only goal for day traders is to make money. Although this is the case most of the time, there is something to be said about the pleasure, satisfaction and gratification that comes from being right.

The feeling of having successfully predicted the behaviour, reactions and fluctuations of the financial markets. That your idea, your strategy and your plan were perfect from the start.

So what do you do? Admit that you were wrong, or go with your initial flawed decision?

This is precisely what you should do. Admit that what you thought was right is not and reduce your losses by changing your strategy. The sunk cost effect implies that you must accept the fact that the cost has already been incurred, that it cannot be recovered and that there is nothing you can do to recover it by continuing on the same wrong path.

To get back to our examples, the best course of action to adopt for each scenario would have been to get out of the toxic relationship, and not to drink that whisky despite the fact that you have already paid and to leave the pottery class since it makes you feel miserable!

To be mistaken is not a blow to your honour. When you made these decisions or made these plans, you had a certain amount of information and data. But things change, and opinions and strategies should change too.

It is certain that you have invested time, effort and money in a specific path, but if this path makes you lose money or your precious time, it would be wise to reconsider your decision.

Imagine that you're building a garage and that 2 months later, you realise that there is an error in the foundations. The error is so significant that there is a possibility that the garage will collapse at some point. It's simply best to admit your error and start the foundation from scratch.

It's easier said than done, but this all makes sense, doesn't it?!

"Anything worth having is worth going for - all the way." - J.R. Ewing



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