What I Learned Losing a Million Dollars - Lessons from Failure, Part 2

In chapter 6, entitled "The Psychological Dynamics of Loss," Jim Paul reviews the process where a market participant experiences a loss, and instead of remaining objective and clearheaded in dealing with the losing position, becomes subjective, ego-driven, and exacerbates the negative outcome.

Market losses are external, objective losses. It's only when you internalize the loss that is becomes subjective. This involves your ego and causes you to view it in a negative way, as a failure, something that is wrong or bad. Since psychology deals with your ego, if you can eliminate ego from the decision making process, you can begin to control the losses caused by psychological factors. The trick to preventing market losses from becoming internal losses is to understand how it happens and then avoiding those processes.

Paul believes a successful investor/speculator/trader must strive to separate ego from their decision making processes. It's an easy lesson to take on its face, but an altogether more difficult lesson to consistently maintain in practice.

[I]t is easy to equate losing money in the market with being wrong. In doing so, you take what had been a decision about money (external) and make it a matter of reputation and pride (internal). You begin to take the market personally, which takes the loss from being objective to being subjective.

An example of personalizing market positions is people's tendency to exit profitable positions and keep unprofitable positions. It's as if profits and losses were a reflection of their intelligence or self-worth; if they take the loss it will make them feel stupid or wrong.

I know that I often feel that a profitable trade proves my market savvy. And likewise, I equate a loss with being wrong, bad, incorrect--a failure. I'm not sure that I agree with Paul when he writes that experiencing these emotions is inherently negative for the market participant. However, I tend to agree that allowing these emotions to linger and influence your investing methods is problematic.

Paul then explains the Kubler-Ross model (Five Stages of Grief) - Denial, Anger, Bargaining, Depression, Acceptance. I first learned of this model from Dennis Miller, back when he had a five-night-a-week talk show in 1992. Upon cancellation, Miller applied each Kubler-Ross stage of grief as the theme of his final five shows. I would guess that the Tuesday show was the most entertaining.

When a market participant experiences a loss (say my current FXP position), it's easy to understand that someone could go through many of the stages of the Kubler-Ross model. But it can happen to a trader who has a profitable position that is not at its peak profitability.

When that happens, he becomes married to the price at which it was the most profitable. He denies that the move is over, gets angry when the market starts to sell off, makes a bargain that he'll get out if the market moves back to that arbitrary point, gets depressed that he didn't get out and maybe even lets the profit turn into a loss, thus slipping again into denial, then anger, etc.

I went through denial when I built up a position in FXP starting at the high $90s and continued through the mid $60s. And I've been pretty depressed about the price action for the last month. But I am also not convinced that all is well in the Chinese market, nor am I convinced that this bear market rally is anything but that. Perhaps in a few months, if the market continues to flourish, then these opinions will make me look like I'm deep in denial. I think I have some objective evidence (in the next post) that shows the market to be overbought and due for a downturn. I will be better served by using objective information, and suppressing emotional inputs in my trading decisions.

Wrapping up Chapter 6, Paul differentiates continuous processes versus discrete processes:

In a continuous process, the participant gets to continuously make and re-make decisions that can affect how much money he makes or loses. On the other hand, a discrete event (e.g., a football game roulette, blackjack or other casino game) has a defined ending point, which is characteristic of external losses. A loss resulting from a discrete event is definitive and not open to interpretation.

Relating back to the process involved in creating my FXP position, the RSI and chart readings, along with the tenor of news stories from China validated each of my purchases all the way down from approximately $100 to $60 per share. The continuous process allowed me to make (currently wrong) decision after decision. The psychological impact of continuous, drawn out losing is quite distinct from the psychological impact of a winning or losing outcome of a discrete event. It's quite a challenge to work through the psychological effects of loss and prevent them from affecting one's objective trading plan. Guess that explains the value of this book.

Soon I'll examine Chapter 7, "The Psychological Fallacies of Risk."