Last Updated on October 1, 2023
The disposition effect in trading is the tendency to sell assets that have made financial gains while holding on to losing assets.
Traders have two main goals. On the one hand, they aim to profit as much as possible from their positions. On the other hand, they want to minimize the potential losses when/if the market turns against them.
These sound like simple and sensible goals. However, they can take a significant toll on a trader’s psychology. The disposition effect is among the most outstanding examples of such behavior. The following article will examine what it is and how it works and explore the strategies traders can use to limit its impact.
Understanding the Mechanics of the Disposition Effect
The disposition effect is a psychological pattern rooted in behavioral finance. It is driven by traders’ cognitive biases and emotional reactions that can consequently lead to suboptimal outcomes.
The behavioral economists Shefrin and Statman coined the term in 1985. They discovered a simple but powerful fact about people. In general, people have a more intense emotional reaction to losing than to winning. This often leads to irrational decision-making, even more so if a trader is inexperienced.
Generally, a stronger emotional reaction to losses than to profits is referred to as risk aversion. This, in turn, can cloud decision-making, especially in individuals that are more prone to prioritize avoiding risks and going for safer choices even when the potential gains are similar. The differences between risk-averse, risk-neutral, and risk-loving professional traders are essential to understanding the disposition effect.
Example of the Disposition Effect
To illustrate, let’s consider a scenario similar to the experiments conducted by behavioral economists. Imagine you are presented with two options. In scenario A, you receive $100; in scenario B, you first receive $200 but then lose $100. In both cases, the net effect will be the same.
However, due to the disposition effect, traders would usually look more favorably at scenario A.
People that experience the disposition effect tend to hold losing positions and sell positions that have recently risen in value. In practice, such positions are more likely to continue in their recent direction and grow. In most cases, the rational decision would be to close losing positions. That way, you can let profitable positions bring more value in time. Instead, individual investors are often quick to lock in profits when there is a real chance for increased gains. At the same time, they allow losses to persist for too long with the hope that they will reverse eventually.
What are the Consequences of the Disposition Effect?
There are two common consequences of the disposition effect in trading – lower portfolio diversification and increased investment risk.
When traders hold on to losing positions, it may limit their ability to reinvest in other positions that will provide greater diversification and yield risk management benefits.
Furthermore, the failure of traders to diversify their portfolios while holding on to losing assets will put investments at risk.
How Can You Avoid the Disposition Effect?
Thankfully there are numerous strategies for avoiding the disposition effect.
Long-Term Strategy
One of the effective strategies for avoiding the disposition effect is to view trades as parts of a long-term strategy rather than individual isolated events. This broader perspective enables traders to reframe their ups and downs, allowing them to view their trading activities more objectively and evade the emotional effect.
Hedonic Framing Technique
The hedonic framing technique relies on mentally framing things in the most pleasing way possible. This involves grouping your losses as one collective entity and viewing your profit as many small wins regardless of how they were achieved.
Also, mentally separating them and grouping a significant gain with a slight loss can be very beneficial when you encounter a consequential loss and a minor gain.
Develop a Structured and Disciplined Investment Strategy
Create a thorough investment strategy that outlines your investment plan, including risk management, diversification, and asset allocation. Ensure you stick to it during market volatility to avoid making irrational and emotional investment decisions.
Also, monitoring and reviewing your investment portfolio regularly will help you spot potential issues early on and make the necessary modifications.
Avoid Being Overconfident
Overconfidence can make you believe you can predict the market or make better decisions than other traders. You have to conduct thorough research regularly and seek professional advice whenever necessary. Keep these things in mind whenever you engage in trading. Close your losing trades promptly and accept the loss while allowing profitable trades to continue. Maintain a sharp and positive mindset throughout the entire process.
You may also like: Mastering Trading Psychology: The Key to Long-Term Success
Takeaway: It is Necessary to Overcome the Disposition Effect
Understanding and managing the disposition effect is important for successful trading. Traders can overcome this psychological hurdle by acknowledging the impact of emotions on decision-making.
When you adopt effective strategies and maintain a disciplined approach, it can lead to a rewarding and profitable trading journey.
