Is your trading suffering from the disposition effect?
The disposition effect is a fundamental part of trading, yet it's still widely misunderstood
The disposition effect is one of myriad biases in behavioural finance, which can affect trading decisions. While it may not be as widely known as herding instinct or loss aversion, finance professor Nicholas Barberis describes it as a "fundamental feature of trading".
What is the disposition effect?
The disposition effect is based on a lethal cocktail of fear and hope. Traders are afraid to lose the minimal earned profit and hope that the price will turn around as losses mount.
As a result, they hang on to unsuccessful securities for too long, and sell those doing well, in order to lock in profit. While taking profits might seem logical, bailing early can mean missing out on greater financial gains.
According to Barberis, stocks that have done well over the past six months tend to keep doing well over the following six months so should be held. Stocks that have done poorly tend to continue to underperform over the next six months and therefore should be sold.
“The disposition effect makes an investor believe the opposite – that a good run must end soon, so sell now, or a poor run must end soon, so hang on,” says Ekaterina Serikova, Currency.com’s trade behaviour analyst. "They could end up selling their best and hanging on to their worst.
The disposition effect was coined by Hersh Shefrin and Meir Statman, who described the tendency to sell well-performing stocks and hold on to losing stocks too long, as a “predisposition towards get-even-itis”.
The disposition effect in behavioural finance is similar to loss aversion, which is where investors fear losses more than they enjoy gains. As a result, they hold a losing trade in the hope that it might reverse in their favour.
The difference between loss aversion and the disposition effect is that investors under the influence of disposition have a greater propensity to sell stock that has gone up in value since purchase to ensure a profit.
However, as with loss aversion, the disposition effect can also cause traders to hang on to investments when they drop in value rather than admitting defeat and accepting their losses.
With our rational, unbiased heads on, it is obvious the best plan of action is to play the long game with profitable shares and ditch poorly performing securities before they decline further.
So, why do investors under the disposition spell keep doing the exact opposite?
What causes the disposition effect?
“While the disposition effect is a fundamental feature of trading, its underlying cause remains unclear,” says Barberis.
Why, he asks, do buyers think they know something the seller doesn’t? Why do investors think the odds don’t apply to them? Why do they think they are the exception to the apparently obvious rule? Why are they so confident?
“Simple psychology says that people believe in themselves and are often proud of what they do,” she says. “That’s fair enough but, apart from making them cocktail party bores, it can affect their behaviour as a trader; they can become conceited about their skills.
“They think they know more than fellow traders in a specific sector and think they’re pretty smart. Overconfidence bias needs to be kept under control because the markets make a fool of us all at some point.”
Israeli psychologists, Daniel Kahneman and Amos Tversky traced the cause of the disposition effect to their prospect theory. This proposes that when we are presented with two equal choices, one having possible gains and the other with possible losses, we are more likely to opt for the former choice even though both would yield the same economic result.
The reason for this, they explain, is that the pain of losing is psychologically twice as powerful as the pleasure of gaining, so people are more willing to take risks to avoid a loss than to make a gain.
The opposite is true when dealing with gains, as people become risk averse. They would rather get an assured, lesser win than take the chance at winning more but also risk getting nothing.
How to recognise the disposition effect
Ask yourself if you:
- Fear losing the minimum profit
- Remain idle during losses and hope for a price swing in the right direction
- Quickly close profitable positions – and miss out on more profit
- Spend too much time in losing trades, rather than taking your losses
If you answered yes to any of these questions, you could be influenced by disposition bias.
How to avoid the disposition effect
The key to overcoming the disposition effect is by following logic rather than emotion.
“You need to treat the markets logically and understand their movements to begin to make more logical, successful trades,” says Serikova. “But simply being aware of the disposition effect is your first step to overcoming it. The next step is to be able to cut your losses and let your profits run.”
There are other steps you can take to minimise its effect.
Have a plan: set a profit target when you open a trade and don’t to be tempted to exit too early.
Stop losses: a study by The Open University Business School in Milton Keynes proves this is an effective tool for inoculating against the disposition effect. Again, stick to the plan and don’t be tempted to be move it further away when in trade.
Look at the relationship between potential loss and potential profit: ideally your potential profit should be at least two to three times the size of your potential loss.
Hedonic framing: this can make gains feel stronger and losses less painful. The idea is that you force yourself to think of:
- A single large gain as a number of smaller gains
- A number of smaller losses as a single large loss
- The combination of a major gain and a minor loss as a net minor gain
- A combined major loss and minor gain as two separate issues
The overnight test: This can help if you are hanging on to stock that is underperforming. Imagine someone has sold the stock overnight and replaced it with cash. The next morning, you can either buy the shares back, or keep the cash and add it to your portfolio. Most people would opt to keep the money.
“Just by changing your perspective (investing cash versus getting rid of the stock), you can gain clarity and have the emotional space to make the decision you know you need to make. Sometimes, that’s all it takes,” says US financial planner Carl Richards.
FURTHER READING: Trading biases to avoid as a novice trader
FURTHER READING: Behavioural finance: how your biases affect trading