Disposition effect trap: how does it impact investors and ways to avoid it?

Successful investment involves a conscious rebellion against one's innate tendency to undermine long-term returns.

In an ideal world, investing is similar to gardening, wherein focus is on cutting the weeds (losers) and watering the flowers (winners).

IRL, the opposite theme dominates. In stock trading, investors tend to cut their profits short by selling winning stocks too soon (also known as "cutting the flower") while stubbornly holding on to losing holdings (watering the weeds).

This behaviour is called the Disposition Effect.

Here we discuss the Disposition Effect, why investors fall victim to it, and how it can be avoided:

Who was the first to describe the disposition effect?

Hersh M. Shefrin and Meir Statman coined the term "disposition effect" – in their 1985 paper titled "The Disposition to Sell Winners Too Early and Ride Losers Too Long: Theory and Evidence."

The research paper is regarded as one of the most well-documented behavioural biases in trading. According to the research paper, people dread losing money considerably more than they prefer winning money.

What causes the disposition effect?

Prone to behavioural biases, investors are driven to sell their successful positions quickly to lock in profits. However, they are averse to selling the losing investments; they rather wait, expecting them to turn into a winner.

A mixture of fear and hope results in the disposition bias. In CFD trading, individuals can be comfortable locking in the minimal earned profit but stick to the loss-making investment thinking that the price will turn around as losses mount.

This bias involves investors exiting successful positions to lock in profit quickly and hanging on to unsuccessful ones for too long, waiting for the price downtrend to reverse.

The disposition effect is primarily motivated by loss aversion, which refers to resistance while realizing losses even if it is a more profitable move.

Both pros and beginner investors are subject to being influenced by the disposition effect.

Despite the desire to be logical and reasonable, it is human nature to act out of fear, pride, and misconceptions

Basically, we can all probably agree that winning comes with a feel-good factor, while losing feels horrible

Hence, the four key tenets of the disposition effect in trading could be summarized:

• Holding losers too long
• Exiting profitable trades too quickly
• Spending too much time on losing trades
• Not giving profitable investments much time to work in your favour

Why do investors easily fall victim to the disposition effect?

If investors sold a position at a loss, it would mean that they were wrong about a trade.

On the other hand, if they are realizing gains on an investment, it would prove that the investors were right.

Simply put, investors seek encouragement to avoid regret.

How social pressures can impact the disposition effect?

Rawley Heimer, a Research Economist at the Federal Reserve Bank of Cleveland, did a study in 2016 that showed that traders' disposition effects went up when they used social networking sites for investing.

This, according to Heimer, is due to a desire for a positive self-image.

It is especially intriguing in a society obsessed with goals and accomplishments!

A research on the trading patterns by Professor Terrance Odean of the University of California found that people sell winning investments because they enjoy basking in the feeling of selling at a profit. It helps them brag or show off even though it might have been logically better to dump the least profitable stock from their investment portfolio.

The satisfaction of profiting from a winner blinds investors to the true benefits of selling a losing investment.

How to avoid the disposition effect?

1. Follow logic, not emotion:

The disposition bias is closely tied to emotions, hence the key to overcome it is to focus on reasoning and logic, rather than emotion

Do you typically sit tight through losses and wait for a price swing to go in the desired direction? What's the turnaround time for closing profitable positions? Are you concerned about losing the minimum profit?

If the answer is "yes" to any of the above questions, the disposition effect may be at work. An investor can tame their mind to overcome the effect.

One of the ways to overcome it is by approaching the markets logically and analyzing their movements; once it is done, an investor would be able to start placing more logical trades that are effective.

The key step in overcoming the disposition effect is realizing that it exists. The next thing to do is learn when to walk away from a losing position and when to let the winning positions run.

2. Broad Framing:

Investors can avoid falling into the disposition effect trap by practicing broad framing, which stresses on viewing all investment portfolio decisions comprehensively.

Broad Framing can help an investor view the investment decisions in the scheme of the many financial decisions in the ecosystem rather than in isolation.

To quote psychologist Daniel Kahneman, the author of “Thinking, Fast and Slow” book:

"You will do yourself a large financial favour if you are able to see each of these gambles as a part of a bundle of small gambles and rehearse the mantra that will get you significantly closer to economic rationality: you win a few, you lose a few"

This quote is worth pondering upon. Broad framing is used by experienced traders to combat the emotional reactions associated with gain and loss.

FAQs

Why is disposition effect harmful to investors?

Over the long-term, investors suffering from the disposition effect tend to experience more losses and fewer gains, by holding on to losing trades and selling the winning ones, too early.

The disposition effect often causes investors to sell the wrong investment.

How market trends influence the disposition effect?

In a research study, Stefan Muhl, and Tõnn Talpsepp found that the disposition effect is stronger in a bear market than a bull market. Also, investors learn more from the disposition effect in a bear market.