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Deceived by Your Own Mind: The Disposition Effect in Trading

Deceived by Your Own Mind: The Disposition Effect in Trading

By Maria Meramveliotaki-Simon

It should have been a great morning; nothing was supposed to disturb the enjoyment of this first cup of coffee and the cinnamon cookie that came along. Unfortunately, it didn’t happen this way. Perhaps my mind had woken up in a trickery mood. It was one of those times when something hadn’t gone quite right and majority of my open positions were at loss. I cannot yet fully comprehend; was it because I haven’t finished my coffee yet and therefore wasn’t as alert as it is required for this kind of decision? Or was it that my mind had managed to skillfully deceive me?  Before rationality had any chance of declaring its presence, my hand had cancelled most of the stop losses applied the previous night. On top of that, I felt rather inclined to close the only position that had made some profit before reaching its expected Take Profit level.

I’d made this mistake so many times in the past.  That’s a classic isn’t it? Let losing trades run and cut winning trades short. Behavioral economists have a name for this tendency to realize gains more than losses . It’s a well- known anomaly described as the “disposition effect”.  Didn’t I know that? I did. But knowledge isn’t wisdom. Human beings will often take decisions that they know aren’t “right” and whilst a part of them tells them “don’t do it”, there is another part screaming “Do it”. Pretty confusing.

But let’s take one thing at a time.

 

The Disposition Effect and why it is so impactful

We all hate losing. That’s why loss must be prevented in every way possible. So when you let your losing trades run, you obviously do not do it because you want to lose more but because an absurdly optimistic part of you tells you that you may and can at least “break even”. This “optimism” however is likely a coping mechanism to help you with the anxiety you experience. Moreover, it is difficult to accept that you may have been wrong in your analysis of the current move or at least entered at the wrong timing. Your mind at this point may have a lot of solid arguments so that you are convinced to keep the losing trades longer; “Market could reverse soon and then I will make back the loss. Just wait for a little longer. Perhaps this is just a short correction.”

These thinking patterns lead us to let the loser run. The possibility of preventing or minimizing the loss, makes us become risk-seeking over losses. On the other hand, the possibility of losing the profit makes us risk averse over gains and we are inclined to close winning trades early.

The Great Deceiver

For our own good, we must find a way to remind ourselves that the voice in our head isn’t always good advice to follow. According to ACT (Acceptance & Commitment Therapy) principles, it is beneficial to view the mind as a separate entity: this entity often helps us to live by our values but it may also undermine or sabotage our efforts.

Based on the example above, I have named my mind “The Great Deceiver”. Before I had any time to argue, it convinced me that I had to close all my trades and I did. I just followed through what the Deceiver suggested: “little profit is better than no profit”, “better close all losing trades now and start anew, there is no need to risk losing more”. The Mind is excellent at its job. It often masquerades itself as realism or logic.

But the critical question here isn’t if what the Mind tells you appears logical. The question is: Is what my mind telling me useful for fulfilling my goals? Will it help me in the long run?  Has my Mind’s approach to guiding me worked so far? And if I keep listening to it, what will the consequences be?

When I closed all the trades, including the winning one, I wasn’t really acting according to the original plan or according to my short-term and long-term trading goals. I had just allowed myself to be intimidated by the Deceiver.

Learning to disobey our Mind when it doesn’t serve us any good isn’t easy. It requires constant practice and persistence. The key is to realize that our thoughts are not literal, accurate representations of reality- they are just thoughts. We can choose not to follow them or believe them. The process of distancing ourselves from our thoughts and seeing them for what they are-streams of words-sensations-passing images- is called defusion. Defusion is a skill that we can all develop with practice and I am going to talk about it in detail in future articles.

 

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