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The Disposition Effect

The Disposition Effect

Trading is a tricky game. On one hand, you want to profit as much as you can on your trades. On the other hand, you want to limit the amount that you lose when your trades are going wrong. These sound like simple and sensible goals, but the psychological static that comes from them being at odds can be great.

One of the greatest examples of this behavior comes in the form of the Disposition Effect. This psychological pattern explains how individual people will tend to behave when it comes to locking in profits and limiting losses. The term was coined by behavioral economists Shefrin and Statman in 1985. They discovered a simple but powerful fact about people. In general, people have a more intense emotional reaction to losing than they do to winning. This often colors their trading with an emotional brush, especially if they are not experienced.

To explain this, let’s look at an example, which is similar to the experiments the two behavioral economists conducted. Imagine you have to pick between two scenarios. In scenario A you get $100, and in scenario B you flip a coin to determine if you get $0 or $200. The expected payout in B is equal to the guaranteed payout in A ($100 expected payout), but the choices of people skew heavily towards Scenario A.

In economics, this is referred to as risk aversion, meaning that people who choose Scenario A prefer to avoid risk. Those who chose Scenario B would be called risk loving. Those who were indifferent between the two would be called risk neutral. A group of professional traders will usually be more risk loving than a non-professional one.

As you may imagine, this psychological effect arises in trading. There it is known as the disposition effect, because it affects the way people dispose of their financial assets. It is the tendency of people to hold their losing positions and sell positions that have recently risen in value. This is not very sensible in trading because in the short term, positions are more likely to keep going in the direction that they have recently gone. The rational decision in most of these cases would be to close losing positions and let profitable positions continue to rise. Instead, individual investors have a habit of trying to avoid losing by closing in a profit early, and letting losses go too long with the hope they will turn around.

Thankfully there are two main strategies for avoiding this behavior. The simple one is to treat the trades as a long term journey, rather than see them as individual isolated ones. By taking this wider viewpoint a trader can reframe the ups and downs and look at them more objectively, escaping the psychological trap explained previously. Then there is the technique known as hedonic framing because it relies on mentally framing things in the most pleasing way possible. Mentally you should frame your losses as one group, and your gains as many small ones, regardless of how they occurred. In addition, when you experience a big loss and a minor gain keep them mentally separate, and group a big gain and a small loss.

Keep these things in mind when you trade. Close your losing trades and accept the loss, and let your winners run. Keep your reactions sharp and positive and your wallet will thank you.