Trading is often said to be a counter intuitive activity. What you think or feel might be the right thing to do is too often not.
Let me give you some examples of what I’m talking about.
When presented with a loss, most people would hold on, hoping that the stock recovers. Too often it doesn’t. When presented with a profit, most people will sell early in fear of seeing any of that profit go back to the market.
There’s nothing worse than doing this only to see the stock take off and generate bigger profits. Simply put, they lift the average of their losses and reduce the average of their wins.
But that doesn’t make sense! I hear you thinking. And you’re right, it doesn’t. But here’s the kicker. This behaviour is so common it’s been given a name – the Disposition Effect.
This is how the vast majority of people tend to think and act in this environment. What causes this apparent meltdown of basic common sense?
It’s not just one thing. Firstly, as humans we actively seek to avoid regret. We can’t bear to think that we might sell the HIH shares only to see them immediately turn around and head north again. The easiest way to avoid this? Don’t sell! And so we hang on to our losers.
Secondly, we seek those things that cause us to feel pride, such as winning trades. So when we see a small profit, we take the money and run. This action is a combination of pride and also fear, fear of price falling.
We know price goes up and down and yet irrationally we fear the latter, so out we go. We promise ourselves we can always get back in later and yet we don’t. We take solace in that all, dare I say, hackneyed cliché: you can’t go broke taking a profit.
I want to argue that one here but we’ll make the point that so doing can seriously impede your performance as a trader. The reason being, you will be reducing the average of your wins. The trader wants smaller losses and bigger wins, that is, to be on the right side of this equation.
Trading is often said to be a counter intuitive activity. What you think or feel might be the right thing to do is too often not.
Let me give you some examples of what I’m talking about.
When presented with a loss, most people would hold on, hoping that the stock recovers. Too often it doesn’t. When presented with a profit, most people will sell early in fear of seeing any of that profit go back to the market.
There’s nothing worse than doing this only to see the stock take off and generate bigger profits. Simply put, they lift the average of their losses and reduce the average of their wins.
But that doesn’t make sense! I hear you thinking. And you’re right, it doesn’t. But here’s the kicker. This behaviour is so common it’s been given a name – the Disposition Effect.
This is how the vast majority of people tend to think and act in this environment. What causes this apparent meltdown of basic common sense?
It’s not just one thing. Firstly, as humans we actively seek to avoid regret. We can’t bear to think that we might sell the HIH shares only to see them immediately turn around and head north again. The easiest way to avoid this? Don’t sell! And so we hang on to our losers.
Secondly, we seek those things that cause us to feel pride, such as winning trades. So when we see a small profit, we take the money and run. This action is a combination of pride and also fear, fear of price falling.
We know price goes up and down and yet irrationally we fear the latter, so out we go. We promise ourselves we can always get back in later and yet we don’t. We take solace in that all, dare I say, hackneyed cliché: you can’t go broke taking a profit.
I want to argue that one here but we’ll make the point that so doing can seriously impede your performance as a trader. The reason being, you will be reducing the average of your wins. The trader wants smaller losses and bigger wins, that is, to be on the right side of this equation.
The trader also realises they need help to get there. That’s where the trading plan comes in. You need to get around or overcome your emotions. And a robust, well-constructed trading plan lets you do that.
