Investor psychology understood through Prospect Theory and diminishing sensitivity

I bought it because I thought it would go up, but an unforeseen sharp drop caused the unrealized loss to keep swelling, I couldn't cut my losses out of fear, I watched the ever-widening unrealized loss and entered a state of cognitive shutdown, repeatedly escaping from reality.

And the feeling of charging in with a foolhardy hold even if I’m prepared to fail... it happens.

When I hesitate to lock in unrealized gains that rose as I expected, I can’t stand seeing the gains start to erode from an unexpected drop, so I lock in some profit just to secure current gains, and immediately after that it reverses and shoots up, a common scenario.

If I had held on without taking profits, it would have been an enormous windfall for sure.

When sudden sharp drops wipe out unrealized gains, individual investors feel they must secure the current profits. The desire not to lose. The urge to retreat with small gains when unrealized gains keep eroding. In this way, they shake and pull at investor psychology and knock them out.

Losing investors only believe information they want to believe. They turn away from inconvenient realities because they don’t want to admit the real events. Because they don’t honestly acknowledge the real events, they widen the wounds and suffer a fatal blow. Even if technical analysis suggests continued decline, they can’t cut losses because they make excuses to escape the reality in front of them.

When you long to recover unrealized losses, you deny a continued decline signal and keep praying for a reversal signal. You deny the fact of unrealized losses and, while clinging to hope for a reversal, you die trying.

A desire to be saved, to feel safe, to wish for upheaval and dramatic events, while at the same time wishing for peace and stability—this contradiction is the nature of humans, who fall into darkness with such desires.

Successful investors openly acknowledge inconvenient realities and incorporate them into chart analysis. They calmly decide whether to cut losses, let unrealized gains grow, or retreat with small profits.

This might be the key to growing unrealized gains... I want money. I don’t want to lose the unrealized gains I’ve earned. I don’t want to admit the losses from unexpected moves. This is the real reason I refuse to cut losses.

The reasons you can’t ride an uptrend and the reasons you can’t cut losses are the same.

If I position myself, maybe it will reverse and become an unrealized loss. If it continues rising without any correction, isn’t this surely the top? I become suspicious and end up thinking that if it’s the top, selling would be fine, and I get pumped up and pushed up.

Oscillator-type technicals stick to the upper limit, and no matter what I think, it keeps rising, so I delay buying and end up crying into my pillow.

Even though I wish for a continued trend, the unexpected strength makes it hard to trust technical analysis. I don’t want to admit reality that I bought late, so I want to believe it’s the ceiling.

But buying is scary. It’s so strong that being late to buy makes me cry, so I trade against the trend by selling.

And when I’m in a losing position, I desperately search for reasons that selling is right. That is how the manipulators push up those who are short selling to the stratosphere.

Turning away from inconvenient realities, surrendering to one's desires, and forcing oneself to short at the ceiling signals leads to self-destruction. Ideally, when oscillators are pegged at the upper limit and rising, there should be no option to short. Unless it’s a short-selling premised on averaging down, I think it’s an act of folly.

Even so, only novices who don’t know the fear of a crash would be naive enough to buy outright. Individual investors only believe what they want to believe, and only see the reality they desire. They escape reality and enter cognitive shutdown. And they keep praying.

This kind of loss-avoidance investor psychology can be explained by prospect theory.

Prospect theory, the law of loss avoidance. The diminishing sensitivity as the amount increases. How investors make judgments when faced with gains or losses.

This is a convenient theory that can specifically explain the psychology of unrealized losses and unrealized gains. I’ve been thinking about the law of loss avoidance, prospect theory.

Prospect theory of loss avoidance is a theory that says the evaluation criterion changes depending on whether you are in a gain or in a loss.

When asked to choose whether to cut losses or not, if cutting losses now means a small loss, but not cutting losses could result in a 50% chance of survival with the loss wiped out and a 50% chance of suffering fatal damage and forced stop-out, most losing investors would choose the latter hold, and the weaker yet greedier investors would hope and die trying.

If you take profits now, you lock in a gain of 10,000 yen unrealized; but if you don’t take profits, there’s a 50% chance of slipping into a loss. The other 50% chance is that unrealized gains will double. I think most investors would choose the former option.

Seeing unrealized gains shrink and fade away is hard to bear, and I think investor psychology that wants to avoid deciding to lock in unrealized losses is part of prospect theory. Those who always lose become more eager to lock in the profits when unrealized gains grow, and feel the frustration watching rising prices while being late to buy.

That’s why they do jumping catches...

Unrealized gains want to be secured, but at the same time they take on the risk of falling into unrealized losses to hope for a recovery of unrealized losses, which leads to fatal damage.

In profit and loss, the losses leave a stronger impression, and the tendency to avoid losses is hard to resist. This psychological habit is called loss aversion. Even with equal amounts, losses leave a stronger impression, and as unrealized losses and gains grow larger, the fear of continued decline in unrealized gains and the pain of realizing losses cannot be resisted.

This feeling is what we call diminishing sensitivity (o^-')b

If unrealized losses are within an acceptable range, many investors can calmly cut losses.

If unrealized losses keep increasing without cutting, you become desensitized to unrealistic figures, fall into a state of cognitive shutdown, and even if unrealized losses exceed your psychological tolerance, you won’t panic. The larger the unrealized loss, the more desensitized you become to losses.

If you bought a position and it hurts as unrealized losses mount, but you stubbornly don’t sell and hold, you may endure a little more crash and become numb. That’s how you push through your own tolerance limit with reality avoidance.

If you’re lucky, you’ll be saved; if unlucky, you’ll suffer a fatal blow (o^-')b

When prices move far away from the price you took a position at, both unrealized losses and gains become less sensitive to the same amount of movement. This desensitization phenomenon is called diminishing sensitivity. You can’t cut losses. You can’t lock in gains. For such investors, ignoring diminishing sensitivity is a form of self-destruction.

If you bought a stock at 5,000 yen and it crashes to 3,000 yen in just a few days, you’ll feel great pain. But still... the pain of continuing to hold and watching it crash further to 2,000 yen is smaller than the pain of cutting losses, so you endure more risk and keep holding, right? Orz

You can understand why investors who can’t cut losses end up trapped in the market.

If a stock bought at 5,000 yen rises to 8,000 yen in a few days and then suddenly drops to 5,500 yen, the mental pain of falling back into a loss after a rapid reversal is far greater than the satisfaction of surpassing the previous high, so they rush to take profits.

To overcome this fear, you need a clear, personal, straightforward method that can prove itself, and you can significantly grow unrealized gains. You understand the feeling of reducing gains and retreating with small profits.

The proper method to generate profits is a trend-following approach. When the trend reverses, switch direction. Don’t rush to take profits. But when you actually trade, gains don’t grow as expected, and delaying cuts leads to fatal damage.

So we’ve understood the dangers of prospect theory and diminishing sensitivity (o^-')b