Two pioneers in the field of behavioral finance, Amos Tversky and Daniel Kahneman, studied the decision making of individuals under uncertainty. One of Tversky and Kahneman’s many conclusions was that investors have an aversion to risk and an inability to realize losses. Hersh Shefrin and Meir Statman used these theories to explain what they called the disposition effect.
What is the disposition effect and what can be learned from it? The disposition effect, quite simply, describes how traders will quickly sell their winners but will hold on to their losers. The disposition effect also helps to explain why individual investors and traders have difficulty succeeding.
The inability to sell losers is cancerous to trading performance. Huge losses that come about from the inability to sell a loser are like digging a deep hole for yourself. The longer you hold a losing trade, the deeper and harder it will be to get out of that hole. The first lesson a trader can gain from the disposition effect is to use Stops. Stops will help make your losses more manageable which, in turn, will give you a chance to make back your losses. I use two types of stops, a Price Stop and a Time Stop. These Stops are my defense against “hole digging.” If the price goes against me, I exit the trade at a pre-determined, hard stop, point. In addition, if the trade has not reached my objective within a certain amount of time, I also will exit the trade. Both of these stops are not mental stops. They are real orders entered into the system. Using Price and Time Stops is the most important lesson that can be learned from the disposition effect.
The second lesson that can be learned from the disposition effect is to leave your ego out of trading. A big ego will contribute to the depth of the hole you are digging. Keep it out of your trading if you really want to succeed. You must come to terms with yourself and understand that it is okay to be wrong on a trade. You must learn this. Trading has a way of making you humble very quickly. The market will usually make you humble the first time you look up from the bottom of that hole you just dug and are viewing the sunlight of being even. Do yourself, and maybe others, a favor, GET RID OF YOUR EGO. It is only then that you stand a chance of succeeding in trading.
The third lesson that traders and investors can gain from understanding the disposition effect is to have patience. Most people have difficulty being patient, but it is, in my opinion, critical to trading success. Although I am a short time frame daytrader, I still am very patient in waiting for my trade setups. I also use patience to allow my trade to reach my price objective. I give my trades time to work out. You will significantly improve your chances of trading successfully if you really understand these three lessons. Smart people learn from the mistakes of others.