How to Avoid the Disposition Effect

The disposition effect is mostly caused by traders’ anxiety. It is a mixture of hope and fear which leads to investors exiting successful positions. Additionally, the investor maintains unsuccessful positions with the hope that the situation will turn around sooner than later. 

Investment biases make the investor believe that a good run won’t last long and that a poor run will end soon. This attitude pushes the investor to sell the rising stock before it has reached its full potential and they keep holding on to the drawing stock longer than they should. 

This tendency shoves the investor to hold on to stocks rather than cut their losses short by holding on to poorly performing stocks. This behavior is called the disposition effect. 

 

The Causes of a Disposition Effect

Both novice and professional investors tend to cash out their gains before realizing their losses, driven by fear and pride. There has been a lot of research into the topic as to why even seasoned traders fall trap to the disposition effect. In conclusion, in all this research three main reasons can be jotted down,

 

Prospect Theory and Loss Aversion

Simply put the prospect theory states that a loss incurred has a deeper emotional effect than any gains achieved even if both are in exact same amount.  

According to several types of research, the most plausible cause of a disposition effect is based on the prospect theory. Despite the theory being an obvious explanation of the disposition effect, it does always produce similar results in every case. The theory resulted in an explanation for how people drive satisfaction in uncertain and risky situations, whereas the theory of utility did not stand. 

On the other hand, there is loss aversion which is the tendency of a trader to feel regret if he sells at a loss, so in order to avoid that regret, the trader keeps holding on to the losing stock in hopes that it might eventually rise up. 

 

Mental Accounting and Emotional Attachment 

The disposition effect is all about one’s aptitude, it is a psychological effect. In several cases, individuals have the tendency to keep mental accounts which causes us to look at each account in isolation. Other than looking at an account in isolation, traders often attach emotions to the account. This leads to irrational decision-making. When investors open a mental account they tend to get emotionally attached to the stock which makes it hard for them to let go of it despite losses. This hypothesis was deduced by Shefrin and Statman who eventually went on to study several other causes of the disposition effect, its solution, and causes. 

 

Fear and Hope

The disposition effect is also caused by fear and hope; Fear of losing from a winning stock and hope that a losing stock will rise up soon. Investors sometimes regret not having sold a stock that was once high. The fear of this regret leads them to sell a stock as soon as the princess starts increasing without waiting for the stock to reach its full potential. Furthermore, some stocks are held on to despite their dropping prices, in the hope that they would eventually rise. This tactic usually leads investors to gain more losses than before. 

 

How to Avoid the Disposition Effect

The disposition effect is more of a psychological tendency. Hence it requires one to train their mind and change habits. It is necessary for traders to keep an aptitude check on themselves to make sure they aren’t enduring losses due to their mental strategies. 

Even experienced investors sometimes fall prey to the disposition effect however the best way to avoid it is by overpowering your cognitive abilities. 

 

Broad Framing

To mitigate the disposition effect one can simply avert the habit of selling improving stocks and avoid holding on to losing ones. However, it’s easier said than done. One cognitive mechanism that has been seen to work well to rid of the disposition effect is known as broad framing. This method involves looking at the bigger picture where you view your financial decision in the scheme of many rather than an isolated one. View each of your financial gambles as part of one big one. By doing so you will get closer to the economic rationality, that you win a few and you lose a few. 

Internalizing this rationale enables even experienced traders to avert their emotional tendency of getting attached to losing stocks. 

 

Self Control

All the theories studied for proving and explaining the disposition effect fall to a similar conclusion, the disposition effect can be avoided by self-control. One is required to train one’s mind and cultivate habits that lead to mitigating the disposition effect. No trade can be successful if it is guided by fear or false hope. 

Final Word
As mentioned before in our blogs, trading requires a certain attitude, aptitude, and psychological training. Similarly in this case too a disposition effect is the result of one’s anxieties, and no good decision can be made under pressure. Trading requires you to keep your nerves calm and maneuver with the influence of facts rather than feelings.

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