Do you have a healthy diet and exercise regularly?
Do you use a non-recognizable, 13-character unique password for each of your online accounts?
Do you floss every time you brush your teeth? And do you put on a seat belt every time you drive?
If you’re like most people, you’d have answered ‘no’ to a number of these questions.
Be A Man. Do The Right Thing.
It’s kind of weird, isn’t it? Why do we find it so hard to make choices that we know are good for us?
Aren’t we naturally motivated to make decisions that benefit us?
Unfortunately, as you might have realized, we often aren’t.
Cause and Effect
Here’s my point: Human beings have a tendency to over-emphasize the observable consequences of the choices they make.
For example, if I used a cheesy pick-up line at a bar and got the girl’s number, I’d immediately recognize the pattern of cause and effect.
Cause: cheesy pick-up line. Effect: get the girl’s number.
So obviously, the next time I’m out looking for a date, I’d use the same pick-up line.
But if I used my birthday as my email password and didn’t experience any digital break-ins into my account, I’d probably use the same easy-to-remember (but also easy to guess) password for all my other online accounts.
Cause: use a convenient password for my email account. Effect: my email account has not been broken into.
This, on it’s own, isn’t much motivation for me to put up with the inconvenience of a unique, highly secure (yet inconvenient) password.
If, however, a malicious person correctly guesses my password and wreaks havoc on my life on the internet, I would suddenly appreciate the benefits of a highly secure password. By then however, it would be too late.
The same goes for the man who eats unhealthily for decades and doesn’t exercise. By the time he gets a heart attack, it would be too late to appreciate the benefits of a healthy lifestyle. Ironically, that is when he will appreciate it the most.
You see, the problem is that oftentimes, the benefits of the better choice is not directly observable, at the time when it is most relevant.
Potential Profit vs Potential Loss
Consider two traders: Trader A and Trader B
2013 turned out to be a bullish year in the markets.
During this period, Trader A posted a 80% return, while Trader B posted a 24% return.
At first glance, it would seem like Trader A is the one you’d rather put your money with.
But what might have happened if 2013 was a bearish year instead?
Let’s say that Trader A would have lost 50% of his capital, while Trader B would have lost just 8%.
Now which trader would you rather put your money with?
“Look What I Avoided For You”
Here’s why it’s difficult for people to stick to a healthy diet and regular exercise – the benefit of not getting high cholesterol (or a heart attack) isn’t directly observable.
In other words, the benefit of a healthy lifestyle is that it helps us avoid the problems of poor health. And because we can’t directly experience what it’s like to have avoided sickness or disease, there isn’t much motivation to make healthy choices.
Now consider these statements by the respective traders at the end of 2013:
Trader A: “I got you a 80% return, congratulations!”
Trader B: “I got you a 24% return, but at the same time I prevented you from losing 50% of your capital.”
Which pitch sounds more appealing?
Instinctively, most people would go with Trader A. Trader B just sounds like he’s giving an excuse for his “weaker” performance.
But when we consider that there’s no way to know in advance if the market was going to be bullish or bearish in 2013, Trader B would be the rational choice.
Unfortunately, people tend to focus only on the observable outcome of a decision, and ignore the avoidance of the unobservable negative outcomes.
It’s a lot easier to say, “look what I achieved” rather than “look what I avoided”.
How This Affects You
Think about your trading approach.
How much of it is influenced by “the potential profits I can make”, instead of “the potential losses I can avoid”?
It isn’t a coincidence that many successful traders and investors are highly risk averse. The one thing Warren Buffett and George Soros have in common, is that they hate to lose more than they like to win.
So instead of focusing on the profits they stand to make from every transaction, their number one priority is to minimize the occurrence and magnitude of potential losses.
This mindset, if good enough for them, would perhaps be good enough for us.