Tendency to hold on to losers too long & sell winners too soon? Traders, time to read this! By Coach
Holding on to loser for dear life and cutting winner trades way too soon sounds familiar?
Have you heard of ''the disposition effect''? In this article I'll explain what I found out about this bad habit and what we, as traders, can do about it. Let's go :)
The disposition effect is a phenomenon in financial markets whereby investors have a tendency to sell investments that have gone up in value and hold onto investments that have gone down in value. This behavior is a result of psychological biases that lead investors to overvalue losses and undervalue gains. Day traders are especially susceptible to the disposition effect because they often make decisions based on their gut instinct or immediate emotion, rather than on careful analysis of the markets.
This article will explore the disposition effect in greater detail, focusing on how it applies to day trading and how traders can use it to their advantage. We will look at how the disposition effect affects trading decisions and why it is so important to be aware of it when making decisions in the markets. We will also examine some strategies that day traders can use to minimize the impact of the disposition effect on their trades.
The 'disposition effect' discovered and named by Hersh Shefrin and Meir Statman in 1985 is based on the idea that investors have a tendency to overvalue losses and undervalue gains. This bias leads investors to be more averse to losses than they are to gains of equal magnitude. For example, when faced with a decision between a 50% gain and a 50% loss, an investor is more likely to choose the 50% gain, even though both outcomes are equal.
This bias is especially pronounced in day trading, where decisions are often made quickly and based on gut instinct. Because day traders are more likely to make decisions based on emotions rather than on careful analysis of the markets, they are more likely to be affected by the disposition effect.
The disposition effect can lead day traders to make poor decisions in the markets. For example, a day trader may be tempted to hold onto a losing trade in the hope that it will eventually turn around and make a profit. This is a bad decision, as it can lead to further losses that could have been avoided. Similarly, a day trader may be tempted to sell a winning trade entirely too early, in order to lock in gains. This can also lead to losses, as the trade may have continued to increase in value had it been held onto.
To minimize the impact of the disposition effect on their trades, day traders can employ a few strategies:
- First, they should always make sure to trade with a plan, and to stick to that plan. This will help to ensure that decisions are made based on careful analysis rather than on emotion.
- Second, they should always assess the potential risks and rewards of each trade before entering into it, and ensure that the potential reward outweighs the potential risk.
- Third, they should always start taking some profits when they arise, and limit losses when they become too large.
- Finally, they should always trade with a stop-loss in place, so that losses are cut off when a certain level is reached.
Another Mindset strategy to consider to overcome the disposition effect would be Hedonic Framing.
Hedonic framing is a mental strategy to maximize the positive impact of gains and minimize the negative impact of losses. It involves dividing gains into smaller units, so the whole gain feels greater, and combining losses into a single event to reduce the negative feeling.
Examples include insurance companies listing policy discounts separately to make customers feel like they are getting a great deal, and people dividing their money into mental accounts to maximize their perceived value.
By being aware of the disposition effect and employing the strategies outlined above, day traders can minimize the impact of this psychological bias on their trading decisions. This can help to ensure that day traders make informed and profitable decisions in the markets.
If you liked this article and want personalized Trading Mindset & Fitness Coaching, feel free to book your one-on-one session with me here: https://calendly.com/coachyoann/free-consultation
Thank you for reading.
Coach Yoann
https://www.coachyoann.com
Disclaimer: This article is for informational and educational purposes only, not financial advice. This article does not constitute an offer or a solicitation or a recommendation to buy or sell any securities, financial product or services by nShape Capital (''Coach Yoann''). Furthermore, nothing in this article is intended to provide tax, legal, or investment advice. All readers should do their Due Diligence before making any financial decision. Click here for full disclaimer: https://www.coachyoann.com/disclaimers
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