Why speculators lose: uncertainty and loss aversion

Key Markets report for Tuesday, 11 August 2026

In his book, “The Intelligent Investor,” Benjamin Graham wrote, “For indeed, the investor’s chief problem – and even his worst enemy – is likely to be himself.” Graham’s statement is very true, and we can attribute this to a number of reasons. The key reason is that investing entails taking risks in the face of uncertainty, since we have no way of knowing what might happen in the markets tomorrow, let alone next month or five years from now.

Other reasons have to do with human psychology and the fact that our mental circuitry simply isn’t equipped to handle speculation in fast-moving markets as we have today. One of our main psychological obstacles is the hardwired loss aversion.

The psychology of loss aversion

Trading and investment management should be regarded as a long-term pursuit where performance accrues as the cumulative result of a long series of investment transactions. However, rather than considering every investment as just one of many, we treat each transaction as a departure from the status quo, where our fear of loss looms larger than our desire for gain.

In fact, the logic we apply to decisions about gains is opposite that which we apply to decisions about losses. This phenomenon was first described by psychologists Daniel Kahneman and Amos Tversky, who named it the “failure of invariance.” Through a series of empirical studies, they discovered that we tend to be strongly risk averse with regard to gains, and risk seeking when faced with losses.

Failure of invariance thus predicts that we tend to be risk averse when preserving a favorable status quo, but prone to taking risks when coping with losses. In trading, this creates the disposition to exit profitable trades too soon, and “work” the losing trades too long, even taking on more risk in order to try and reverse the losses.

The pressure to recover losses can lead traders to escalate risk to massive proportions, which can lead to disastrous outcomes. The first concrete, high profile case of this tendency that I came across in the early years of my trading career was that of the hedge fund manager Victor Niederhoffer. In 1996, he was rated the world’s top fund manager, but in October 1997, after 15 years of outstanding performance, his business came to an abrupt end: his entire fund was wiped out in a single day when the market moved against his huge short positions in S&P 500 put options.

The fact that an investor with top-notch credentials, experience and a stellar track record took such massive risk on a single trade was simply astonishing. Mr. Niederhoffer’s fatal trade was partly a consequence of loss aversion: in August 1997 his fund sustained heavy losses on investments in Thailand’s currency and stock market. In September, after recovering some losses, his fund was still down nearly 40% for the year. The pressure to recuperate the losses led him to excessive risk taking, a mistake which he warned against repeatedly in his book, “The Education of a Speculator”.

Let the losses run and cut your profits short

Loss aversion explains why it is so difficult for most people to follow the often quoted formula for successful investing: “let the profits run and cut losses short.” We are strongly predisposed to take profits while they are a sure thing, and let losses run, gambling that the markets will turn in our favor.

In other words, we seem to be hardwired to follow the exact opposite formula – to cut our profits short and let losses run. This creates a strong tendency in most traders and investors to gradually lose ground against the markets.

Loss aversion underscores the fact that our mental faculties simply aren’t suited to the task of speculating in fast moving securities markets. Human brain is the product of our natural evolution, designed to solve problems of survival we confronted through our evolutionary history. During more than 99% of that time, we lived as foragers in small nomadic bands, and in that environment, loss aversion bias did make good sense.

The evolutionary hardwiring

With no refrigerators, bank vaults or stock certificates, most improvements to our natural state had sharply diminishing marginal utility. More food is good, but there’s only so much you can eat or hoard before it starts to become a liability. By contrast, reduced access to food, or an injury could rapidly spell “game over.” MIT professor Andrew Lo formulated this point very succintly when he said that,

“This notion of loss aversion, being more aggressive when you’re losing and more conservative when you’re winning, is a very, very smart thing to do when you’re being hunted on the plains of the African savannah. However, it’s not a smart thing to do when you’re on the floor of the New York Stock Exchange.”

Our mental circuitry, however, did not evolve in modern security exchanges but in environment more similar to the African savannahs, and that circuitry is hardwired and extremely difficult to override.

Trend following to the rescue

I was in my mid-20s when I came across Victor Niederhoffer well before his notorious debacle and read his book. To me, he seemed to be the kind of successful professional I aspired to become, and the news of his failure hit me like a ton of bricks. What is the point of being a successful investor if your career ends in a fatal, humiliating blunder.

If this could happen to Niederhoffer, I reasoned, it could happen to anyone, and it did happen to many rock-star investors including the “market wizard” Staney Druckenmiller and the pair of nobel prize laureates, Myron Scholes and Robert Merton. Indeed, the graveyard of superstar traders is littered with such exalted names.

To sidestep all the pitfalls that caused such capital failures, it was necessary to find a way to isolate the decision-making process from loss aversion and other emotional biases that cause the investor to be his own “chief problem and even his worst enemy,” and make sure that we can let our profits run and cut our losses short sustainably, and regardless of the market environment.

An emotions-free, sound intellectual framework

As our fellow trend follower Warren Buffett put it, “What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.” I know, someone will counter and say that Buffett is a value investor, but he’s no such thing as I discussed in this article. Either way, that same idea was what guided the creation of I-System, which generates trading decisions purely on the basis of market price fluctuations and trends with zero emotions and zero distractions.

For investors who want to do better than Niederhoffer, Druckenmiller, nobel prize economists, Cathy Wood and other market wizards, systematic trend following offers that alternative and should be used, at the very least, as a reality and a regular source of second opinion on the markets. Perhaps the best part is that the very same intellectual framework that enables us to navigate market trends in stocks and bonds also allows us to trade crude oil, gold, silver, bitcoin or any other market with exactly the same quality of trading decisions.

To learn more about TrendCompass reports please check our main TrendCompass web page. We encourage you to also have a read through our TrendCompass User Manual page. For U.S. investors: an investable, fully managed portfolio based on I-System TrendFollowing is available from our partner advisory (more about it here).

Today’s trading signals

With yesterday’s closing prices we have the following changes for the Key Markets portfolio: