What is a disposition effect?
Similar to loss-aversion, disposition bias is caused by a mixture of fear and hope. Traders are afraid to lose minimal earned profit and hope that the price will turnaround as losses mount.
This bias involves investors exiting successful positions to lock in profit very quickly, but also hanging on to unsuccessful ones for too long, waiting for the price to turnaround. Trading trends often show that investments performing well will continue to perform well, so should be held, and investments performing badly will continue to perform badly, so should be sold.
The disposition effect in behavioural finance makes an investor believe the opposite – that a good run must end soon, so sell now, or a poor run must end soon, and so hang on. They could end up selling their best and hanging on to their worst. Prone to behavioural biases, we only have ourselves to blame in our poor investment performance.
Who was the first to describe the disposition effect?
The disposition effect was first identified by Meir Statman and Hersh Shefrin in their work “The Disposition to Sell Winners Too Early and Ride Losers Too Long: Theory and Evidence”, published in 1985.
In their research, the scientists claimed that “people dislike incurring losses much more than they enjoy making gains”. As a result, “investors hold onto stocks that have lost value and are eager to sell stocks that have risen in value”. The researchers coined the term “disposition effect”, which has been considered one of the leading behavioural biases in trading since then.
Disposition bias in trading and investing
Suffering from the disposition effect, traders usually hold on to losing trades and sell the winning ones. Why do people behave like this? Selling a position at a loss would mean that they (investors) were wrong on a trade. Nevertheless, realising gains proves that the investors were right. Simply put, investors try to avoid regret and are looking for encouragement.
There are two major reasons why selling to soon and taking small profits may not be such a good idea.
Great stocks are hard to find
Did you know how difficult and rare it is to find truly great companies to trade? According to some long-term research, tracking the largest 3000 stocks listed on the US stock market, 39% of the shares had a negative total returns, 64% of shares underperformed the Russel 3000 index. Great investments are hard to spot. If you're lucky enough to own some truly outstanding shares, you'd better think twice before selling them.
The best example of selling too soon is provided by Warren Buffet. Duly impressed by the Disney's performance, Mr. Buffet bought a significant share of Disney stock for 31 cents per share. The decision may have become brilliant, because now the Disney stock sells at $147! However, Warren Buffet decided not to wait long and sold his shares at 48 cents a year later. It means that he got just a quick 55% profit but missed a 21,290% gain.
Selling winners is tax inefficient
Taxes could drastically reduce the benefits of growth over time. For tax purposes, traders should postpone paying taxes, by means of holding their profitable investments longer. At the same time, they should capture tax losses by selling their losing investments.
Causes of disposition bias
Disposition effect could be detrimental to investor’s performance. The tendency to sell winning trades and hold onto losing trades is deeply rooted in investor’s psychology. The authors of the disposition effect, Shefrin and Statman, identified 4 possible causes for this behavioural bias
In 1979, Amos Tversky and Daniel Kahneman traced the cause of the disposition bias to the “prospect theory”. The theory suggests that when a person is given two equal choices, one described from the perspective of probable gains and the other from the perspective of probable losses, the person will more likely choose the former variant, even though both could bring the same economic result. The theory predicts that traders feel the pain of loss twice stronger than the joy of gain.
Selling at a loss, even if it seems totally rational, means admitting a trader was wrong, which is hard for many people. Holding the stock allows him to avoid the feeling of regret, which follows the mistakes we make.
In case of a winning trade, holding onto it means risking the profit a trader has already made. Taking a small profit instead creates the feeling of pride.
According to Shefrin and Statman, traders tend to “open a new mental account” for every investment. By doing so, they focus on the performance of each and every trade, instead of tracking the performance of their portfolio as a whole. This is an example of a narrow framing. It makes hard to sell a losing stock, because traders see it as closing the mental account at a loss.
Though the rational part of our mind reminds us that selling winners and not letting losers go is a wrong behavioural pattern, we still often struggle to take the necessary actions. It means that trades often don’t have enough discipline and self-control to sell the losers and not to sell winners too quickly.
Although it’s unlikely that we will be able to bury the disposition bias for good, it is possible to learn how to reduce its influence on our decision-making.
How to avoid the disposition effect?
Tied strongly to emotions, the key to overcoming the disposition bias is by looking towards logic rather than emotion. Ask yourself – do you have a tendency to remain idle during losses and hope for a price swing in the expected direction? How quickly do you close your profitable positions? Do you fear losing the minimum profit?
If you answered yes to any of these questions, you could be influenced by the disposition effect. Overcome it by treating the markets logically and understanding their movements, and in doing so, you can start making more logical, successful trades. By being aware of the disposition effect, you are on your first step to overcoming it. The next step is to be able to cut your losses and let your profits run.