Dr. Steenbarger on booking losses before they occur

There is a meaningful difference between trading to win and trading to not lose. The average person feels more psychological pain over a loss than they feel pleasure over a gain–particularly once they have already “booked” that gain mentally.

When we enter a trade, we expect to be paid out. Mentally, we book a potential profit. When a loss materializes, it is the unexpected event–and we respond more strongly to the unexpected than to the familiar.

What is the solution to this dilemma? The answer, surprisingly, is to book losses before they occur.

It’s human nature to not want to think about such unpleasant things as losses. But by knowing our maximum possible loss in advance and by mentally rehearsing what we’ll do on those occasions when the loss occurs, we normalize the losing process. That divests it of its emotional grip.

We can never eliminate loss from life or trading; nor can we repeal the basic uncertainties of markets. What we *can* do is develop an edge in the marketplace and, over the course of many trades, let that edge accumulate in our favor.

Source: http://traderfeed.blogspot.com/2006/09/trading-to-win-vs-trading-to-not-lose.html

The danger of leverage

In the United States and many other industrial countries, the recent financial crisis contributed to the longest and most severe economic contraction since the Great Depression. The rapid expansion in the use of borrowed money, or leverage, by households in recent years, is one factor that may help account for the virulence of the downturn.

Household leverage ratios: Debt/Disposable income

Going forward, the efforts of households in many countries to reduce their elevated debt loads via increased saving could result in sluggish recoveries of consumer spending. Higher saving rates and correspondingly lower rates of domestic consumption growth would mean that a larger share of GDP growth would need to come from business investment, net exports, or government spending. Debt reduction might also be accomplished via various forms of default, such as real estate short sales, foreclosures, and bankruptcies. But such deleveraging involves significant costs for consumers, including tax liabilities on forgiven debt, legal fees, and lower credit scores.

Source: FRBSF Economic Letter, Reuven Glick and Kevin Lansing