The simple way to combat the endowment effect in forex trading
We are wired to be bad traders.
The things that made mankind so successful are what makes us so vulnerable to bad decisions.
We hate losses so much more than we love gains. Evolutionarily, the reason is obvious: Thousands of generations who would have starved if they didn't stockpile enough for Winter. And if they had a bit extra, so what?
A more complex trap is the endowment effect, which is something the WSJ writes about today. It means that once we possess something, we want more money for it than we normally would.
If you wanted a ForexLive mug, you might pay $10 for it. But once you had it on your desk for awhile, you wouldn't sell it to a trading friend for $20.
We like holding onto our possessions even when it makes sense to sell. So an old bicycle is only worth $50 but we demand $100 in a sale because we're attached to it.
It's 100% natural, even primates do it.
In markets, it can be devastating. Many traders were holding losing cable positions yesterday. They didn't like them, wouldn't be buying if they had been flat but felt strangely compelled to cling to them until they blew up.
How to combat the endowment effect
The solution is surprisingly easy but the tough part is identifying it. We are blind to our biases.
The first warning is that you're holding something that's a loser. If you have a position that's underwater, you need to ask yourself why.
Consider that it's the endowment effect. Consider that you don't want to take a loss. Consider that the reason you bought it in the first place is gone and that whatever it's trading at right now is fair value.
Those aren't easy questions to answer but here's the solution:
Sell it.
One of the beautiful things about forex trading is that the costs are miniscule. One of the easiest ways to tell if you're in a bad trade is by selling it. Get on your mt4 trading platform and unload the position.
Once you've let it go, the endowment effect is no longer a factor, you can see the pros and cons a bit more clearly.
If you still want to own it, go ahead and buy it back. The insight and clear-headedness you gain will be far more valuable than the few pips you lose in transaction costs.
