For the most stock market, the sensible strategy is to buy a sufficiently diversified stock portfolio at low prices and stay for the long-term (position trading).
But, many people who trade and invest find it challenging to resist the appeal of the ‘playing the market’; buying and selling as we have feelings about what the market trend is and where it is going.
One of the predicaments with such trading and investment approaches is a well-known bias that many traders and investors endure, the inclination to hold on to positions which are trading at a loss and to quickly dump them when becoming profitable. This tendency is often referred to as the ‘disposition outcome.’
Did anyone ever bought a stock or whatever and watched the price to drop and not done anything at all? On the other hand, did anyone ever bought a stock or whatever, and witnessed the price rise rapidly and disposed of too soon?
The good news is that everyone has done it; the disposition outcome is a natural behavior. The sad story is, this form of trading is associated with unsatisfactory performance
In the stock market, everyone will tell you trade to cut your market losses and let your winners roll on! However, this part of freely provided advice isn't so simple to perform. Seldom there is the inner voice in the in your gut that keeps on saying - If only or what if, the market scenario is wrong.
Conversely, when your position is trading at a loss, wholly and surely, we find lots of more important things to do other than dump it and start over, finish watching the movie, or watch television or go shopping again to distract ourselves from reality.
Many research investigations conducted the study of the investors and traders to determine facts that are most likely to hold on to losers and sell premature gains. They have conjectured that human emotions very much play a central role in the stock market trading behavior.
The research found that those traders and investors who rely on gut instinct, intuition, or emotions when forming decisions are much more tending to hold on to losers and sell the gains prematurely. But, traders and investors who could reappraise their feelings were a lot less likely to reveal this bias. Let us illustrate how this happens.
Let us take a step back from the stock market investment scenario and direct our attention to the decision-making process. Ever since the arrival of Functional Magnetic Resonance Imaging (FMRI), scientists and researchers were granted the capability to observe and examine what transpires inside the human head while we accomplish specific tasks.
It did not take very long for scientists and researchers to get humans to perform risky choices while in an FMRI device. What they have noticed that portions of the human brain which processes emotion means, the prefrontal cortex as well as the amygdala, which were highly stimulated whenever people made risky decisions.
Furthermore, scientists and researchers couldn't separate while an individual was using emotions derived from cognition; thinking and emoting are connect.
Trading and investing in the markets requires making many decisions under severe risk conditions. Therefore, emotions are expected when producing these decisions, and there is a disposition outcome.
Scientists and researchers recognized that when enduring a market loss, the emotion which is associated is a disappointment. However, when encountering profit state, two feelings are affected: jubilation and satisfaction.
As Daniel Kahneman (Nobel Memorial co-prize winner in economic sciences) suggested, most people have two systems: System 1 - intuitive, actively influenced by emotions, quick, and System 2 - as sluggish, deliberative and analytical.
However, the most recent research advises that these aren't, as Kahneman proposes, separate systems, the concept of two different (yet, overlapping) thought processes still seem to carry precious value.
Something Daniel Kahneman applies to as System 1 tenders more usage of automatic response, emotional and process systems, while the much more effortful System 2, which depends primarily on the application of restricted working memory within the human brain and is, therefore, more effortful and sluggish.
First and foremost, people, and especially traders and investors, differ in how much they depend on System 1 and 2. Some traders and investors exhibit great faith in following gut intuitions, the rest of people put strong influence on analytical judgment, and others bank on both or neither one of them.
The current research employed a psychometric study to cover over 280 traders and investors’ dependence on System 1 and 2 thought processes. The researches analyzed these same traders and investors’ stock market judgments (approximately 20,000) over three years to discern to what degree the traders and investors held losses and sold early gains.
What they have found out that gut feel matters’ although not in a big way. Those traders and investors who relied a lot more on the emotional signals (System 1) when making trading or investment choices were a lot more prone to hold losing positions and sell premature gains. The weight of happiness and regret is a lot more noticeable for these traders and investors.
Consequently, traders and investors who relied further on analytical decisions (System 2), dumped the losses and continued to hold gains much longer? This, however, was not the case; they could not find a distinct link connecting analytical decisions and this preference.
The traders and investors who recorded a high level of analytical decisions were nothing more or less than apt to the disposition effect. Stating I only do 'rational' decision making doesn't seem to work.
Beside System 1 and System 2, they also examined the regulation of investors and trader's emotions. In other words, how did investors and traders manage the emotional encounter of investing in the equity market? And did any of this had an influence on whether they hang-on to stock market losses and sold the gains prematurely?
James Gross, of the Department of Psychology at Stanford University, has explored the research on the regulation subject of emotion and has classified two basic strategies:
Furthermore, research proposes that reapprisal is far more useful at lessening emotion, which leads to encountering more real feelings, and therefore, it can reduce hesitation to cut market losses.
In their research, they weighed the degree to which investors and traders rely on expressive suppression and/or reappraisal when making an investment in the stock market.
What they have discovered that investors and traders who often use reappraisal were in all likelihood to hold on to winnings and sell at a loss. But, inhibiting emotions revealed no connection to selling losses or gains.
The take-away message from their research can be summed up in five points:
In stock market investing and trading business emotions are prevalent in decision-making, and managing emotions is a learned knack that takes some time to develop.
If one is excited to improve one's investing accomplishment, then time should be assigned to the emotional phase of investing and trading as well as analyzing the markets.