Disposition Effect

“Money is made by sitting, not trading” – Jesse Livermore.

Most of us enter the trade at the correct time but fail to capitalize the profit because of our human nature. We close the position before the take profit or stop loss levels feeling that position is not in our favour.

People dislike losing significantly more than they enjoy winning and hence sell the profitable positions earlier but they tend to happily sit on loss positions making them grow. It’s called disposition effect!

Suppose there are two situations.

In Situation A, you have 1000 INR for investment with two choices.

  • In Choice A, you have 50% chance of making 1000 INR and 50% chance of making 0 INR.
  • In Choice B, you have 100% chance of making 500 INR

In Situation B, you have 2000 INR for investment with the same two choices.

An overwhelming majority of participants chose “B” in the first scenario and “A” in the second. This suggested that “people are willing to settle for a reasonable level of gains (even if they have a reasonable chance of earning more), but are willing to engage in risk-seeking behaviors where they can limit their losses.”

In short, loss of 500 INR creates more pain than joy created by a profit of 500 INR. The disposition effect can be minimized by a mental approach called “hedonic framing”.

Suppose you have a trade which has a loss and you’re holding the position just praying that it goes in your direction. It’s called pray mode when you lose all rationalization and cannot mentally accept the loss and hence don’t realize it making it a bigger loss. Just close that position with a/few profit trade(s). It reduces the disposition effect over time.

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