The First Loss is The CHEAPEST!

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  • on October 19th, 2008

There is a song in my head the last week called ‘The First Cut is The Deepest ‘. I think it applies to the carnage in the market and what Dr. Pearlman sets out to explain below. If you trade or invest, you will get cut and the best way to deal with a cut…is swiftly.

I had my pal Dr. Phil Pearlman create a post for me on ‘The Psychology of Realizing Losses ‘

Average market participants dread losing money in the market as much as agoraphobics dread the market itself. And sometimes they cope in similar maladaptive ways by avoiding realization of the fear, rational problem solving and resolution…

In fact, one of my all time favorite terms in all of trading is realizing losses. There is a wonderful double meaning there that gets to the heart of why investors get crushed during vicious bear phases and why we are presently witnessing even some of the best with outsized losses as evidenced by the hedge fund blow ups occurring on a daily basis now.

Away from finance, when you realize something you become conscious of it, you acknowledge it and can then begin to process and adapt to the implications. Things that are extremely traumatic or frightening are more difficult to realize and so sometimes we cope by simply refusing to do it. This denial works great at first as u go about your business but after a while the unrealized stuff begins to weigh u down even more just as any unresolved problem festers over time…

And so it is with market participants. I wont bore you here with discussions of prospect theory and the evolutionary effects of resource scarcity suffice to say humans are freaking petrified of losing money.

And when the losses are bad they become so frightened and anxious that they devise all types of stupid ways to avoid realization from putting the quarterly mutual fund statement at the bottom of the mail pile to, in the case of more active traders, increasing risk dramatically so that they might get even and so will no longer have losses to realize..

Think about it, it is so rich. hedge funds getting shmeissed have not simply dishonored discipline but have actually increased risk into their losses in an irrational attempt to avoid loss realization. So when the margin call does the realizing for them they are already blown up…

For those of u familiar w psychobabble.. this is a classic example of the neurotic paradox ie: the very fear you are running from the fastest is kicking the living shit out of u…

Look there is no simple answer here. During periods like this you will come across armchair shrinks on the cnbc or in the wsj who will spout all kinds of behavioral finance 101 jargon at you and then simply say something like ‘well dont do this’ but i assure u they have no clue what they are talking about… They might as well be saying to the suicidal depressive ‘yo buck up guy snap out of it.’

Sorry no answer you can either realize it or not…

Thanks Phil. I would just add that if you are going to invest in this or any market, you will HAVE realized losses. You must have a plan for accepting them.

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