Do you have the tendency to sell your winners too early and ride losers too long? Don’t worry, most people do and this has a negative impact on your overall trading performance. It’s called the disposition effect (DE) and is related to 2 important theories that explain how we make decisions.The first one is the prospect theory, developed by Daniel Kahneman & Amos Tversky in 1979. According to this theory, individuals take decisions based on the psychological value of gains and losses calculated from a reference point, rather than focussing on the final result. They also found that the fear of losing an amount is between 1.5 to 2.5 more intense than the hope of gaining that same amount. Hence we become risk- seekers when we have a loss and risk-averse when we have a gain.
The second one is mental accounting, introduced by Richard Thaler in 1985. According to this theory, individuals divide their wealth into different mental accounts and value each decision they face separately for each mental account. They then apply decision making rules without considering potential interactions between the decisions and the consequences at the global level. An investor will open a new mental account each time he takes a position in a specific security, and consider it separately from the portfolio. He may be unwilling to realise a loss for a given position as this loss will be recorded in that mental account, even though it harms the global portfolio performance. The investor prefers self-esteem (pride from realising profits) to regret (due to erroneous investment decisions).
Different empirical studies have been conducted over the last 25 years to explore this bias and to understand which factors show a relationship with DE and how it can be reduced. One of the most recent contributions to the literature was made by Bellofatto, De Winne and D’Hondt. They used data from an online brokerage house where they studied the behaviour of 51.000 retail investors during the 1999-2012 period.
In this study, they provide strong evidence for the theory that the disposition effect varies both across individual investors and over time. They show amongst other findings that:
- Financial sophistication helps investors reduce behavioural bias.
- Stop-loss orders is an effective tool for investors to dampen their DE.
- Investors who use the help of professionals also show a significantly lower DE.
- DE is significantly lower when markets are falling and especially during crisis periods such as the financial crisis of 2008.
- The type of stock traded, and especially financial stocks, has an impact on DE.
The study also found that a minority, around 23% of the investors, showed a reverse DE. These tend to be the financially more sophisticated investors.
To read more about this study, click here.
Although we haven’t tested this, we think our approach and screener help dampen your DE significantly as well. This is how:
- We invest for a period of 1 year. If after 1 year the stock is not in the model anymore or lost momentum, we sell the position.
- We select stocks based on our value screeners product that scans more than 22.300 stocks. We encourage our members to look outside their country boundaries for cheaper stocks.
- We invest systematically, in bull or bear markets. Even if there’s significantly less opportunities, our screener always shows the cheapest companies, often with a significant margin of safety.
Even if this is recommended in this study, we’re not really keen on stop-loss orders. We tend to buy stocks with smaller capitalisations and these can be quite volatile at times.
Although we haven’t conducted any scientific tests, we did run some tests on our 12-year backtest portfolios used in our papers. We found that stop-loss orders had a significant impact on overall performance and reduced the average yearly return.