Are You Your Own Worst Enemy?

Have you ever sold a winning position just to watch the shares continue to run higher? How about your losers? Have you ever held onto hope and a losing position for longer than you should? 

Then you might be suffering from the disposition effect. 

The good news is it’s very common, and once you know about it, there are ways you can keep this psychological phenomenon in check. 

This behavior was brought into the mainstream by Terrance Odean back in 1998 when he analyzed trading records from 1987 to 1993 and published his findings in The Journal of Finance. 

His findings demonstrated a significant preference for selling winners and holding losers, providing hard evidence for what economist Shefrin and finance professor Statman coined the “disposition effect” back in 1985. 

Investors realized gains about 1.5 times the rate of losses. Yes, psychologically you’re 50% more likely to sell a winning stock than sell a loser, despite the fact that most winners continue to outperform and losers continue to underperform. 

When stocks move into winner territory, investors tend to act risk-averse. They want to lock in those gains before they disappear. 

When stocks are down, investors exhibit risk-seeking behaviors to avoid the actual loss. The opportunity starts to play out more like a gamble than an investment. Once you sell that stock, you’ve locked in your “bad decision.” If the loss is still simply on paper, you can tell yourself that it’s still a good decision and will come back up. 

So, what can we do to limit this behavior from eating into our returns? 

The Mighty Stop-Loss 

Many of us have worked hard to try and take the emotion out of our trading. That’s a lot easier said than done when behavioral finance concepts like this one are lurking in the mainstream consciousness. Understanding these common pitfalls is always the first step. From there, we want to have a plan for both our winners and our losers. 

One tool that should be in your toolbox is the stop-loss order. 

This is a specific order that you place with your broker to automatically sell a security when it meets a certain criterion. The criteria or trigger can be set at any level below the present market price. 

A standard stop-loss order requires you to enter a specific price as the trigger. 

For example, if you are holding a stock with a price of $100, you might put in a stop-loss order for $97. You’re trying not to lose money anymore. You’re essentially creating an exit plan for when you need to move on. 

If shares hit that price or below, your order turns into a market order. Meaning, your shares will be sold immediately at the market price. 

There’s also a version of this called a stop-limit order. It acts exactly the same, except when triggered, it turns your sell order into a limit order. You have to enter both your limit or trigger price and desired limit price when you place the limit order. The additional risk here is if the stock continues to head south, bypassing your limit order. If that happens, your shares won’t sell. 

You can use these on losers or winners. Utilizing a stop-loss order on a losing position forces you to set a target price where you will cut your losses and move on to a better position. On a winner, it allows you to protect your gain against slides in the opposite direction. However, there is a stop-loss order that works a little better for winners. 

A trailing stop-loss allows you to enter a trigger that moves with the share price. If your $100 stock climbs to $120, you’re not going to want to keep your limit order at $97. These orders let you set a percentage or a dollar amount that will move up with shares. 

A Few More Tips 

Stop-losses are specific orders that you can place with your broker at any time. Some of you may not want to set up the orders to trigger automatically, but you can still use these concepts to fight the disposition effect. 

Instead of putting in a stop-loss order, you could use your broker’s built-in price alerts. Most brokers let you set these up to notify you via email or text when share prices hit certain levels. You can pick your “stop-loss” levels and then enter them as price alerts. This option requires you to make the trade manually. 

This can be more appealing if you don’t like automatic trading. But it could leave you vulnerable to the thoughts and patterns of the disposition effect. 

Another way to protect your returns is to simply put yourself on a regular schedule to reanalyze your positions, especially losers. Instead of just hoping those shares will recover, you should take the time to determine whether your original investment thesis still holds up. 

And finally, another way to soften the blow of locking in losses is to think of them as a swap. Essentially, you want to look for a better investment that you can buy right now with the cash you’re about to free up. Don’t see it as taking a loss; you’re swapping it out for a better opportunity. 

So, I’m curious, do you sometimes feel like you are the victim of the disposition effect? Do you have tools in place to ensure that you don’t let your emotions sabotage your returns, even a little bit? Let me know.