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The Disposition Effect

The Disposition Effect

Trading is tricky. On the one hand, you want to profit as much as you can on your trades. On the other hand, you want to limit the amount you lose when your trades are going wrong. These sound like simple and sensible goals. However, 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.

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The disposition effect is a psychological pattern. It explains how individual people will tend to behave when trying to lock in profits and limiting losses. 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 they do to winning. This often colors their trading with an emotional brush. Even more so if the trader is inexperienced.

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Example

To explain this, let’s look at an example. This is going to be similar to the experiments the two behavioral economists conducted. Imagine you have to pick between two scenarios. In scenario A, you get $100. Conversely, 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). However, the choices of people skew heavily towards Scenario A.

In economics, this is what we cal risk aversion. It means 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. This phenomenon is what we call the disposition effect. The name comes from the way it affects how people dispose of their financial assets. People tend to hold their losing positions and sell positions that have recently risen in value. This is not very sensible in trading. In the short term, positions are more likely to keep going in the direction they have recently gone. The rational decision in most of these cases would be to close losing positions. That way, you can let profitable positions continue to rise. Instead, individual investors have a habit of avoiding losing by closing in a profit early and letting losses go too long with the hope they will turn around.

How can you avoid the disposition effect?

Thankfully there are two main strategies for avoiding the disposition effect. 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. Doing so helps them escape the disposition effect. 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 profit as many small wins, 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. That’s how you avoid the disposition effect. Keep your reactions sharp and positive, and your wallet will thank you.