The Disposition Effect

The disposition effect is a common behavioural bias whereby investors are more likely to sell positions that have increased in value, and more likely to hold positions that have declined in value. While it might seem intuitive to lock in the gains and hold losses waiting for a rebound, this behaviour can result in both diminished gains and unnecessary losses.

This effect can be particularly disruptive when running momentum or trend following strategies, which rely entirely on a stock’s continued movement in the current direction. But by not allowing gains to run and holding onto losers, we risk disrupting the momentum anomaly and diminishing our overall return.

When trading, if we continuously monitor stocks, we can experience discomfort from phenomena such as the Gambler’s Fallacy, which can make a collapse of a positive run feel almost inevitable. I have personally been experiencing this firsthand with the stock CU6, which I’ve held since January. There have been multiple milestones at which I’ve thought “surely this run can’t continue” and I should take profit, but ultimately, I would have regretted this more. Conversely, a position I held in DRO experienced a significant collapse earlier in the year, but it felt like it just had to bounce back any day now, it did not, and I held it until I received the exit signal.

Ultimately succumbing to these whims can have a significant impact on our overall returns, which is why we follow a 100% systematic process for our personal strategies, allowing computer algorithms to make bias-free decisions for us. When trading discretionary positions such as in our US and ASX discretionary portfolios, discipline is important, and we make sure to establish stop-losses early and stick to them once placed. If a profit-target is established, it is done before the position is opened and not moved thereafter.

If you’re interested in trading our systematic or discretionary strategies, you can sign up to our free-trial here.