The disposition effect is a psychological phenomenon that makes an investor hold their assets and investments when in loss, and sell them when making a profit.
So a trader is likely to sell their assets early when the prices increase and hold the assets when in red. As a result, the trader is likely to lose out on gains and on the contrary have their portfolio in red too.
This effect can also be explained by the Loss Aversion as well as Regret Effect
Loss aversion basically explains that the feeling of losing money > feeling of gaining money. Example: The pain of losing INR500 is more than the pleasure of finding INR500.
Regret Theory explains that the person will make a decision based upon the anticipation of regret. So the investor is more likely to make decisions keeping fear of regret in mind. In an extended bull market, an investor might keep investing without thinking about the cash reserve as he doesn’t wanna regret it later.
Although both the theories give a fairly good explanation trying to justify the effect, they don’t take into consideration the motivation and objective of investing.
In a study by Grinblatt and Keloharju in 2001, it was found that the probability of selling a stock with moderate losses was nearly half that of ones with gains. In other words, people were selling stocks with gains quicker than selling stocks with losses.
While an investor should theoretically perform the contrast of disposition effect while trading.
How to avoid the Disposition Effect?
The best way to avoid the disposition effect is to take decisions with logic rather than emotions. Keep doing things opposite to what you usually do. Hold and be patient when seeing a profit, and try to reposition yourself when facing a loss. You might panic initially, but the outcome may be super lucrative for you.
Keep asking yourself 2 questions to see if you’ll be influenced by the disposition effect
Do I fear losing this minimum profit?
Do I remain idle when I am suffering losses in trading?