By Dr. Van Tharp
Do you remember playing with a toy called the Chinese Finger Trap when you were a child? This toy is a woven straw cylinder with an opening at each end just large enough for a finger. Once you insert a finger in each end, you are in the trap. You pull to get out and the trap closes around your fingers. The harder you pull to get out, the tighter the cylinder compresses around your fingers. The more you struggle with the trap, the more ensnared you become. Only when you let go and relax does the trap let go of you.
Investment losses form a similar trap for most people–the Loss Trap. The more an investor resists losses, the more ensnared the investor becomes in the Loss Trap–a psychological snare with numerous hidden factors that keep people locked into it. The more the investor struggles with losses, the worse the losses become.
Consider the case of Brad, an investor who wants to make a killing in a speculative stock. First, he pays $5,000 for a stock, including nearly $200 in expenses. These transaction costs start the investment off at a loss, so Brad is already in the trap. He has passed a critical point in time, the point of no return, where thinking often becomes irrational and risk takes on its real meaning.
Soon, the stock goes down in value to $4,300. Brad thinks to himself, “I have a loss, but it will turn around.” These are normal thoughts, resulting from his natural inclination to justify his stock purchase. As a result, he reasons, “I can afford to lose a few hundred dollars more to make a nice profit.” When people are in the Loss Trap, they avoid the sure loss and take an unwise gamble that often leads to greater losses.
The stock goes down further, so that it is only worth $3,800. Somehow, Brad reasons, the stock has gone down so far that it cannot possibly go down any more. He can afford to risk a few hundred dollars more to make back his stake. Brad has now lost sight of his original profit goal, if he had one, and just wants to break even on this trade.
What happens next?
The stock goes down to $2,500. Our investor cannot give up now. His stock hasn’t been priced this low in years. Besides, he has “spent” $2,500 on it at this point. His stock must have bottomed, so the risk of holding onto it is minimal–he thinks. He holds onto his investment and soon only has $500 left. Each possible loss that our investor envisions is compared against what has already been lost. Each time he imagines that his investment has reached rock bottom, he can envision no further risk. The stock can only go up. He already has so much at stake that he might as well continue holding the investment. And with each loss the trap gets tighter. Unfortunately, the only way to get out of such a trap is to let go of the trade, but the investor often is financially exhausted by that time.