Disposition effect

The disposition effect is traders’ tendency to close their profitable position too quickly, while keeping their losing position open for too long. Learn more about it in our educational guide.

What is a disposition effect?

Disposition effect bias refers to one’s tendency to prematurely sell assets that have made financial gains, while holding on to assets that are losing money.

Highlights

The disposition effect refers to the tendency for traders to hold on to losing positions and close winning positions.
From a psychological perspective, the disposition bias can be explained by looking at two key factors – loss aversion and cognitive dissonance.
A disposition effect example could be a trader closing a short CFD position on shares of a company whose stock is performing well and holding on to those in a company whose stock is performing poorly.

The psychology of the disposition effect

The disposition effect refers to the tendency for traders to hold onto losing positions for longer and sell profitable positions rapidly. This behaviour is said to be driven by the desire to avoid regret and preserve self-esteem.

From a psychological perspective, the disposition bias 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 leads to traders being reluctant to sell losing positions because they fear regret and negative emotions associated with realising a loss.
Cognitive dissonance. This occurs when individuals hold conflicting beliefs of attitudes. A trader may believe a particular stock will perform well but experience a loss instead. This creates a discomfort and the trader may hold on to the losing position in order to reduce this cognitive dissonance.

Where does the disposition effect occur?

The disposition effect in trading occurs when individuals hold on to losing positions for too long and sell profitable positions quickly. This can occur in various financial markets, such as the stock market, options and futures markets.

Examples of the disposition effect

Let’s say you want to plan a holiday. You look at your portfolio to decide how to finance these travel plans.

You narrow it down to selling shares in two different companies – Company A is up in value from when you purchased it, and Company B is down in value from when you bought it. 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.

The consequences of the disposition effect

There are several potential consequences of the disposition effect. One of them could be lower returns. The effect could lead to lower investment returns. By holding on to losing positions for too long and selling profitable positions too quickly, investors may fail to fully realise the potential gains of their positions.

Below are a few other possible consequences:

Reduced diversification. The disposition effect could lead to a failure to diversify one’s portfolio. Holding on to losing positions may limit trader’s ability to reinvest into other positions that could provide greater diversification and risk management benefits.
Increased risk. By failing to diversify their portfolios and holding on to losing assets, traders may increase their overall investment risk. This may be especially problematic in volatile markets, where losses can accumulate quickly.
Emotional stress: The disposition effect could also lead to emotional stress for investors. 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 and potential missed opportunities.

Avoiding the disposition effect

There are several strategies traders could deploy if they hoped to avoid the disposition.

The first could be to set investment goals that align with their financial objectives. This could help you stay focused on the long term and avoid making impulsive decisions based on short-term market fluctuations.

Below are some other strategies that a trader could consider using to potentially manage the disposition effect:

Creating a disciplined investment plan. Developing a disciplined investment plan that outlines your investment strategy, including asset allocation, diversification, and risk management. Sticking to your investment plan, even during periods of market volatility, to avoid making emotional investment decisions.
Monitoring your portfolio regularly. Keeping track of your portfolio performance and regularly reviewing your investment holdings to ensure they are aligned with your objectives. Regular portfolio monitoring could help you identify any potential red flags early on and make necessary adjustments.
Avoiding overconfidence bias. Overconfidence bias could lead investors to believe they are able to predict the market or make better investment decisions than others. Avoiding falling prey to overconfidence bias by conducting thorough research and seeking the advice of financial professionals when necessary.

Conclusion

Disposition effect bias refers to one’s tendency to prematurely sell assets that have made financial gains, while holding on to assets that are losing money. From a psychological perspective, the disposition bias could be explained by looking at two key factors: loss aversion and cognitive dissonance.

There are several potential consequences of the disposition effect, such as lower returns, increased risk, emotional stress and less diversification. Traders hoping to mitigate the effect could make use of several strategies, including setting investment goals, creating a disciplined investment plan, avoiding overconfidence bias, and monitoring their portfolio regularly.