Did you know that when your stock holdings go up and down, your brain releases chemicals to generate a response from you?
When stocks rise, you get a shot of dopamine and serotonin. It’s your brain’s way of encouraging you to do more of the same. Making money feels good, because your brain thinks it promotes survival.
When a stock falls in price (especially if it falls sharply), your brain sends signals to your adrenal cortex to release cortisol. This induces fear and panic. It wants to get you out of the situation.
I’ve been doing a lot of research into this lately. I’m interested in how the brain responds to certain investing events. If we understand the responses, we can perhaps make better decisions under pressure.
I mention it to you today because I’ve realised that I don’t talk about our losses enough. Losses are annoying and disappointing. There’s no way around it.
But they’re also a part of the game. If you want to play the market, you have to learn to accept losses.
Instead of taking a loss and glossing over it — pretending that it didn’t really happen — the most important thing you can do is examine the losing trade. You want to work out whether you did the right thing — a ‘good’ loss — or whether you made a mistake — an avoidable loss.
Like everyone else, I’m guilty of glossing over losses too. I’ll often write Crisis & Opportunity subscribers a quick email saying we were stopped out and that it’s time to sell and move on.
The reason for that comes back to the chemicals stimulated by your brain.
When we lose money, cortisol flows through our neural pathways. Losing money is a threat to our survival, and cortisol is the body’s way of telling you to avoid that action. That’s why we shy away from talking about losses.
This all happens on a subconscious level. You don’t know about the cortisol, and you don’t really think a loss (assuming it’s a small one) is a threat to your survival.
But tell that to your old mammalian brain. It’s evolved to get you the hell out of these situations pronto and ask questions later, if at all. Hence the shot of cortisol to make you fearful and unhappy; as a result, you want to end the bad feeling and get out of the situation.
But the human brain has a cortex as well, and this battles with the mammalian part of our brain, known as the limbic system. The mammal brain reacts. The cortex thinks and reasons.
So, while you get a shot of fear when a stock falls, your cortex also rationalises it and tries to calm you down. You don’t like the feeling, but your cortex tells you it’s not the end of the world. After all, you bought the stock. Surely it will bounce back, you reason.
In short, the human brain is a disaster when it comes to investing or trading. The battle for control between the limbic system and the cortex creates all sorts of problems.
This is why it’s so crucial to have an investment process. And a stop-loss system is one of the most important parts of the investing process.
A stop-loss system is like having a referee to control the battle between the two parts of your brain. The limbic system panics, screaming ‘sell’ at the first sign of trouble (which may be no trouble at all), while your cortex is telling it to calm down.
Both have different aims.
At this point you need the stop-loss referee to come in and draw a line in the sand to tell the other guys that no one’s listening to their babble, and that the decision has been made.
The referee is your will and desire to stick to this system and ignore the other two.
And that’s not easy to do.
Which is why it’s always important to review your trades: To make sure your system is robust, and to reinforce the discipline of knowing when to sell.
Editor, Crisis & Opportunity
Editor’s note: The above article is an edited extract from Crisis & Opportunity.