Gentle Reminder of the Disposition Effect

A few weeks ago, I wrote herewithin about a natural phenomenon: When things go well, we tend to ascribe our success to our abilities—our disposition.  But when they go wrong, we tend to blame external factors—our situation.

Finished.  Done.  Quick conclusion.  Move on.

But wait a minute…could it be that that ‘quick conclusion’ was made at a time where we got tired of thinking? Disposition Effect

That type of quick conclusions means that not only are we unlikely to accurately assess our on-going level of ignorance, we are also unlikely to develop the appropriate methods to deal with it.  Hence, we’d never learn very much.

So, if it’s luck rather than skill that accounted for the majority of investor gains during a strong uptrend, would we be prepared to deal skillfully with the inevitable decline?

Hardly.

Instead, many investors would be susceptible to a variety of self-deceptions.

The most common of these is known as the Disposition Effect, which is the tendency to view the intrinsic value and prospects of stocks we own more favorably than we would if we didn’t already own them.

We easily rationalize holding on to losers by imagining a brighter future for the equity in question.

Moreover, we also want to avoid the possibility that 1) we sell for a loss, and 2) that the stock then goes back up, which would make us feel doubly bad. (Hmm, didn’t some of us already do a bit too much of that back in 2008?)

Therefore, when we weigh these two possible future outcomes, it’s easy to vote for the one with the happy ending.  And, as a bonus, we’re more likely to sell winners than losers—a bad or at least not such a great choice!

To help bring a bit more objectivity into the decision-making process, choose this simple mind experiment and ask yourself what you would advise a friend to do with the same trade, if it was his/hers, and not yours.

Taking this “advice approach” may not be the best way to inject rationality into your decision-making (and it’s certainly not the only way), but I find it useful to imagine what advice we would give to another person, particularly someone we care a lot about.

And if you perceive a discrepancy between the two situations, you’ve just awakened (yourself) to reality. Disposition Effect - Think about it

What would also help is avoiding any tool that would highlight your purchase price (or your current gain or loss) against that purchase price.  At least this would reduce the obviousness of that particular anchor, and thus mitigate its effect.

Incidentally, the reason I am able to write about this is not because I’m an expert; in truth, I seldom write about the things that I know.  Instead, I write about the things that are deeply challenging for me right now.

 

“One half of the troubles of this life can be traced to saying ‘yes’ too quickly and not saying ‘no’ soon enough.” — Josh Billings, humourist

 

Other biases in that context: Endowment Effect, Regret, and Loss Aversion.

6 Comments

  1. Hi Andy

    good post there.

    One can feel on top of the world when things are going well for him but feel the bottom when things does not. People needs to understand that life goes in cycle and you can draw an average ascending line there and be on top of the average, that would be great enough.

    • Love your metaphor with the “average ascending line”.

      So life is like the stock market. Volatile in the short-term but in the long term with a nice upwards trajectory. Quite natural actually, as the majority of people roaming Mother Earth wake up the morning with the intention to make their own life a bit better step by step.

  2. @Quote”A few weeks ago, I wrote herewithin about a natural phenomenon: When things go well, we tend to ascribe our success to our abilities—our disposition. But when they go wrong, we tend to blame external factors—our situation.”Unquote

    Most people only like to hear the good news or praises and constantly evade their weakness to be brought up. It’s an escape from reality and sense of self-denial.

    It’s only when we are open to radical truth that we can truly evolve. open to receive, understand, accept, adapt and effect change. Sounds easy?

    • Honest self-reflection is a good remedy against self-deception.
      Definitely not easy! There’s a whole further art to finding the truth and accomplishing value from inside our often too human mind: we have to learn our own flaws, overcome our biases, get ourselves into good emotional shape to confront the truth and do what needs doing.
      To make our stupidity obvious, even to ourselves — this is the heart of overcoming biases.

  3. Hi Andy

    Luck do affect significantly to our life achievements but it shouldn’t stop us from doing our best. When we do our best, our “luck” improve too.

    Seriously, the more i read about what others say about stocks, the more confused I am. Permanent portfolio is somehow the right way for me.

    Cheers!

    • Hi Frugal Daddy,

      I wholeheartedly agree. “Lucky people” share traits that tend to make them luckier than others. Being observant, open-minded, friendly, relaxed, and optimistic invites luck their way.

      Preparation is another key to having good luck. So do not forget to prepare your permanent portfolio for those nasty Black Swan events (Put Options anyone?). Because LUCK is also Learning to Use Correct Knowledge.

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