The Ultimate Guide to Avoiding the Disposition Effect in Trading

Author: James Clark

How to Avoid the Disposition Effect in Trading

Stock trading is a game of fight or flight. Investors that fear losing money often hold on to losing trades for too long and selling winning ones prematurely. Such actions trigger the Disposition Effect, which is one of the most common trading mistakes. Luckily, there are ways to avoid this, but it involves getting to the root of the problem before solving it.

In this post, we’ll share the causes of the Disposition Effect in trading and provide readers with effective ways to avoid it.

Understanding the Disposition Effect in Trading

The Disposition Effect simply describes our tendency to sell profitable assets prematurely while holding on to losing ones for too long. As a result, some traders lose their winning investments just to ensure a profit without considering the bigger picture. Similarly, some traders keep a losing investment, hoping for the tides to turn and make it profitable.

The primary cause of this behavioral bias is a blend of fear and hope. Other causes include:

1. Regret Aversion

Selling at a loss means that your strategy was ineffective. Most traders find admitting their mistakes difficult so they hold on to trade to avoid the feeling of regret. Similarly, taking a small profit from a premature sale gives traders a sense of achievement.

2. Mental Accounting

Most traders try to focus on every trade’s performance instead of tracking their performance as a whole. By doing this, selling a losing trade becomes increasingly difficult, because you’re tracking each trade individually. Hence, selling at a loss makes it more painful.

3. Prospect Theory

To traders, the pain of loss is much stronger than the joy of profit. As a result, many traders opt for selling a winning trade quickly and keep the losing trade longer.

How to Avoid the Disposition Effect in Trading

The key to countering the Disposition Effect is to place logic over emotion. Ask yourself:

 Do you hope for a price swing during unfavorable conditions?
 Do you quickly close your profitable positions?
 Are you afraid of losing the minimum profit?

If you answered ‘yes’ to any of these questions, you’re likely affected by the Disposition bias. Below are some things you can do to avoid the Disposition Effect in trading:

1. Follow the Trading Rules and Establish a Sell Discipline

Nobody likes selling at a loss. However, if there’s one thing you need to know about trading is that the only thing that’s guaranteed is a loss. While losing is a part of the game, you can decide how much you lose you can afford. You can establish a sell discipline and sell a stock once the loss reaches a predetermined percentage of the purchase price.

2. Improve Your Self Awareness by Keeping a Diary

Most athletes improve by tracking their performance or learning from their mistakes. Keeping a diary allows you to include information that can help you identify behavioral and decision-making patterns. This information includes investment thesis, portfolio allocation, your emotional and physical state, and your risk limit, etc.

3. Don’t Overthink About Losses

Losing is part of the game. Instead, you should focus on collective wins and establish a positive risk/reward ratio. With a positive ratio, you can focus on your performance as a whole instead of breaking it down for each investment.

Bottom Line

Many traders experience the Disposition Effect, especially in their early trading days. Fortunately, they can avoid it by understanding the causes and fix them using our advice. In the end, you must let logic prevail, see the bigger picture, and believe in your investments.

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