How to avoid the disposition effect and endowment effect when trading

Wherever you are in your trading journey, gaining a better understanding of ‘effects’ is crucial for making objective moves in the markets. 

Read on to learn more about how two prevalent effects – the disposition effect and the endowment effect – can impact your trading activities, and how to avoid them.

What are ‘effects’ in trading?

In trading, ‘effects’ refer to the psychological and behavioural tendencies that can influence traders’ decision-making processes. These effects, often rooted in cognitive biases and emotional responses, can play a crucial role in shaping the movements of financial markets. 

Examples of such effects include the ‘disposition effect’, where traders hold onto losing positions for too long due to aversion to realising losses, or the ‘overconfidence bias’, where traders may overestimate their own abilities and take excessive risks. 

Recognising and understanding these effects is critical for traders to make more informed and objective decisions in the face of human psychology’s inherent impact on trading behaviour.

The disposition effect

Disposition effect meaning

The disposition effect is characterised by traders’ tendency to close profitable positions too quickly, while keeping losing positions open for too long.

Traders affected by the disposition effect often make decisions based on emotional responses rather than objective, rational analyses of market conditions. 

Why does the disposition effect happen?

The disposition effect can often be driven by the desire to avoid regret and preserve self-esteem. From a psychological perspective, the disposition effect could be explained by looking at two key factors. 

• Loss aversion. This refers to the tendency for individuals to feel the pain of losses more than the pleasure of gains. It causes traders to be reluctant to exit losing positions because they fear the regret and negative emotions associated with realising a loss. 

• Cognitive dissonance. This occurs when individuals hold conflicting beliefs or attitudes. A trader may believe a particular stock will perform well, but experience a loss instead. This creates discomfort, and the trader may hold on to the losing position in order to reduce this cognitive dissonance. 

How can the disposition effect impact trading?

There can be several potential consequences of the disposition effect. 

One of them could be lower returns. By holding on to losing positions for too long, and selling profitable positions too quickly, traders may fail to fully realise gains.  

Here are some other possible consequences of the disposition effect for traders.

• Reduced diversification. The disposition effect could lead to a failure to diversify your portfolio. Holding on to losing positions may limit your ability to take other positions that could provide greater diversification and risk-management benefits.

• Increased risk. By failing to diversify your portfolio, and holding on to losing assets, you may increase your overall risk. This may be especially problematic in volatile markets, where losses can accumulate quickly.

• Emotional stress. The disposition effect could also heighten emotional stress. Holding on to losing positions could create a sense of regret and anxiety, while selling winning positions too quickly could lead to feelings of disappointment about potential missed opportunities.

Disposition effect example

Here’s an example of the disposition effect in action. 

Let’s say you want to plan a holiday. You look at your portfolio to decide how to finance your travel plans, and you narrow it down to selling shares in two different companies. Company A shares are up higher than when you purchased them, and company B shares are lower. 

Selling shares in either company would give you enough money for your holiday. You decide to sell shares in company A, despite the fact it has increased in value, and keep the declining shares in company B. As a result, you continue to incur losses with company B.*

How to avoid the disposition effect

As with other risk-management strategies, there are several strategies you could employ to help avoid the disposition effect.

Firstly, you could set trading goals that align with your financial objectives. This could help you stay focused on the long term, and avoid making impulsive decisions based on short-term market fluctuations or emotions. 

You could also develop a disciplined plan that outlines your trading strategy, including choice of assets, diversification, and risk management. Sticking to your plan – even during periods of market volatility – could help you avoid opening or closing positions based on emotions. You can learn more about trading strategies in our comprehensive guides.

Keeping track of your portfolio performance and regularly reviewing your positions to ensure they are aligned with your objectives is another way to help you avoid making trading decisions based on emotions. This way, you can identify any potential red flags early on and make necessary adjustments along the way.

Another factor you should be aware of here is avoiding overconfidence bias, which can lead traders to believe they’re able to predict the market or make better trading decisions than others. You should avoid falling prey to overconfidence bias by conducting thorough research and seeking the advice of financial professionals when necessary. You could also try a demo trading account to practise trading and develop your trading strategies without risking real money.

The endowment effect

Endowment effect definition

The endowment effect – also known as the divestiture aversion – is a type of emotional bias that leads people to consider something they own to be worth more than it actually is. 

The effect often involves items that have an emotional or symbolic connection with their owners, leading them to place more value in said item than they would if they didn’t own it.

Why does the endowment effect happen?

It could be argued that the endowment effect is a by-product of loss aversion. For many, the fear of making a loss may be stronger than the allure of making a gain. As a result, they might try to avoid losing out by keeping things as they are. This develops into the status quo – whether it is in terms of possessions or assets – being assigned a higher value. 

People also tend to underestimate the opportunity costs of a transaction, not thinking about the non-monetary elements of any sort of deal. This could lead them to putting too high a monetary value on an item, especially if it’s something they own.

How can the endowment effect impact trading?

The endowment effect can significantly impact the choices traders make by influencing their perception of the value of their assets. In turn, traders’ willingness to buy or sell their assets may be based on emotional attachments as opposed to an objective market analysis.

Recognising and understanding the endowment effect is vital if you are to assess when to adjust your portfolio objectively, rather than basing your decisions on emotions.

Endowment effect examples

An example of the endowment effect in action in day-to-day life is when people buy things they don’t need. A big part of the endowment effect is the idea of psychological ownership. If, for instance, someone offers you a free trial, on a psychological level it could feel like you already own the product so you will spend money on it, even if you don’t really need or want it. 

In the context of trading, an endowment effect example could be when traders overvalue their existing holdings compared to the market’s current valuation. This overvaluation could lead to substandard trading decisions, such as a trader being reluctant to sell their assets, even when market conditions suggest it would be rational to do so. 

Conversely, traders may be hesitant to buy new assets, as they perceive their current holdings as more valuable than potential alternatives.

How to avoid the endowment effect

As with other risk-management strategies, there are several tactics you could deploy to help avoid or lessen the impact of the endowment effect.

Firstly, keep the current market values of your asset front of mind. Always research the price your asset is actually going for, not what you would like it to go for. 

Having a clear idea of what your goals are and how you intend to reach them is another key way to help avoid the endowment effect. Doing so could help provide focus and clarity, as well as potentially helping prevent attachment to individual trades.

Additionally, having a varied portfolio could help prevent you from falling victim to the endowment effect. Having a wider range of assets may lessen the likelihood of becoming attached to one of them, or overvaluing one asset’s price.

*Past performance is not a reliable indicator of future results

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