Every Investor’s Biggest Flaw and How We Fix It

BY KEITH KAPLAN
CEO, TRADESMITH

I’ve been thinking about the relationship between human emotions and money for my entire career at TradeSmith.

Money seems like this cold, calculating kind of field where emotions play no role. Yet, they always do. These things are intimately tied together.

It’s not immediately clear why. But I think I know.

Ancient Brains in a Modern World

For the vast majority of time humans have been on the planet, there has been no form of money or investment. We lived by hunting, gathering, and bartering with others. There was no unit of account – just survival.

We’ve really only been thinking about “money” since the dawn of civilization – a few thousand years or so.

And for most of even that relatively short time, money was only a concern for a tiny sliver of the population – kings, dukes… the top 0.01% of society.

As society progressed into the modern age, more and more people have had to use money… and think about it in a complex way.

Through this lens, we can see what money really represents and why it has such an emotional pull on us.

It’s our livelihood. In the same way that our ability to bring down a wildebeest with a sharp stick meant our livelihood for tens of thousands of years, we’ve swapped that with our ability to acquire money.

We don’t hunt for food anymore, we grocery shop… with money. We don’t stake our claim on a piece of land by threat of violence… we buy a home or rent from a property owner… with money. We pay for access to clean water and heating and cooling… with money.

And not only do we spend our money to live, we risk it to get ahead by buying assets that we hope will go up. This multiplies the complexity manyfold.

Money and investment has been a big adjustment for the human psyche in a short period of time. This should explain why people have such visceral, emotional reactions to both making or losing it.

These reactions are almost always harmful. That’s why everything we do at TradeSmith is to save you from acting on your emotions… and rely on the cold, calculating data that produces far better outcomes.

Now, I’d like to say I came up with all this myself. But the truth is, I owe a lot to two men who were among the first to reveal the emotional connection to money: Daniel Kahneman and Richard Thaler.

The Giants’ Shoulders We Stand On

In 1675, Isaac Newton wrote, “if I have seen further [than others], it is by standing on the shoulders of giants.”

We won’t claim we’ve “seen further” than Kahneman and Thaler. But we have applied their philosophies in a unique way that keeps you from irrational decisions.

One of their biggest contributions to behavior science was the idea of “loss aversion.” That’s where we feel a great deal more emotional pain from losing money on our investments than joy when they gain.

The feeling of pain from a total loss, even one from $1 to $0, is far worse than the feeling of joy from doubling your money from $1 to $2.

Loss aversion is what drives investors toward “panic selling.” They hate the idea of losing so much, they immediately (and irrationally) accept large losses out of fear that those losses will get even larger.

Market history shows us that asset prices always recover eventually. (And sometimes sooner than you’d think.) Therefore, panic selling is never a good idea.

Every market crash has proved to be a buying opportunity… and any desperate action to sell assets at a loss tends to foster regret later.

That’s why we built TradeStops. It’s a simple software solution that gives you a clear level to sell any asset you own, down to the cent.

With it, you don’t sweat market selloffs. You know exactly when to act – and that’s when an asset you own crosses into our Red Zone.

Let’s look at a couple examples…

Below is a chart of the S&P 500 index from back in 2020, with our TradeStops signals marked in yellow and red.

The yellow line is a “warning” level. When the S&P crosses into the Yellow Zone, it means it’s at about the halfway point between its high and the level we consider the right place to sell.

The right place to sell is the Red Zone, or the red line above. We determine that by looking at each asset’s long-term volatility patterns, calculated as our Volatility Quotient.

As you can see, as markets quickly shifted risk-off in early 2020, TradeStops had you in the Yellow Zone on Feb. 25… and out of stocks on Feb. 27, 2020, when the S&P 500 hit the Red Zone.

Then on March 27, 2020, as stocks began to recover, TradeStops flashed a new green Entry signal. That was the sign to get back into stocks.

Of course, we all know what happened next. Stocks staged a massive recovery and wound up closing 2020 higher than they started… despite a crash that took out a third of the index’s value.

What this chart shows you is the advantage TradeStops gives you. It gives you simple steps to follow to overcome your human, emotional reactions.

Let’s look at another big asset we track: gold, represented below by the SPDR Gold Shares ETF (GLD).

GLD started 2024 at about $195 per share and last traded hands at more than $335. That’s a roughly 70% gain, and it’s also outperforming stocks this year.

Our recommended sell price for GLD is down at about $295, determined by our Red Zone. But I want you to pay attention to the green bubble at the bottom left of the chart.

That’s our entry signal. It flashes when an asset has risen enough from the Red Zone, which for GLD was back on Dec. 29, 2023.

Had you followed that signal, you’d have enjoyed the entirety of 2024 and 2025’s gold gains. Now, you’d be in a great position to hold on through a short-term downturn.

So, not only does our algorithm help you from avoiding needless losses… it helps you get into assets at the right time.

That way, you can ride them higher and be that much further from a loss in the first place.

What we discussed today is just one of many lessons we’ve learned from behavioral psychology – both from studying Kahneman and Thaler, and from our own research.

The only good time to sell stocks is when the data supports it. Not our emotions.

We’ve cracked the code on when that time is. And so long as you stay tuned with us, whether you subscribe to everything we create or nothing at all, you have our promise that we’ll tell you when we get a true sell signal on the markets that’s worth paying attention to.

In the meantime, I always love to hear from you at feedback@TradeSmithDaily.com with any thoughts or questions you might have. I’ll look to publish my responses in a future issue, if we think they’ll be helpful for your fellow readers.

Every Investor’s Biggest Flaw and How We Fix It