Toward the end of 2012 I authored a post that discussed a phenomenon academics in the area of behavioral finance term the Disposition Effect. This is a bias theorized and observed in which traders are prone to hold on to losers too long and close out winners too quickly. Anyone who has been involved in the markets for a decent amount of time while have likely heard the equivalent of cut your losses short and let your winners run, which is advice essentially meant to counter the psychological impact of the Disposition Effect without actually naming it.
In that prior post I talked about how this bias can be just as problematic for those taking part in social trading as trading on their own. The inclination to take sure profits can be very strong.
Of course there are ways one can work to overcome the desire to cut winners short and let losers run. Some traders opt for totally automated trading to take emotion completely out of the picture. Those who don’t go that route face significant challenges.
A recent paper looks at the impact on the inclination toward Disposition Effect influences on trading from the perspective of experience and sophistication. The authors find that higher levels of either measure can reduce the impact considerably, but neither can eliminate it on its own. Even when combined, high experience and sophistication will only eliminate the “hold the losers” side of the equation. It does not completely rid one of the inclination to close winning trades.
To restate the above, you can largely overcome the impact of the Disposition Effect on your trading through education and practice. That will make taking losses tolerable, but there will likely still be some compulsion to want to close out winning trades early. Knowing this, though, should help you overcome that bias.
Following on this subject, there’s another paper which looks at the Disposition Effect somewhat differently than most have to date. It firstly supports the case of the paper I just talked about in that it indicates the larger accounts (suggestive of more sophisticated and/or experienced traders) tend to show less inclination toward exiting winners and holding losers. This, however, is only the case when looking at individual trades. When looking at things from a portfolio perspective (they use forex accounts, so think multiple trades being on at once) the Disposition Effect influences continue.
Basically, the second paper says more experienced and sophisticated traders may be able to overcome the Disposition Effect on any given trade, but they still fall victim to it when managing a group of active positions. This is another thing for you to keep in mind, whether you’re doing your own trading or engaging in social trading. The easy solution is to have a specific plan to stick to it.