Another well known saying in trading is that you’re supposed to cut your losses and let your winners run. Again, if you actually drill down into the performance of most traders you’ll find that most of them actually do the opposite. They tend to cut their winners and let their losses run. The same holds true across the institutional divide, it’s not just retail traders who fall prey to this phenomenon. 

Now, if good trading performance can be summed up in these tidy little pieces of trading wisdom, then how come most people get them the wrong way around? Furthermore, how can they act so obviously against their own best interests?

The Disposition Effect

A big part of this comes down to a cognitive bias that has been observed in behavioural finance known as the Disposition Effect. Cognitive biases are little short-circuits in human reasoning that cause us to make sub-optimal choices in certain scenarios. The disciplines of Behavioural Economics and Behavioural Finance have gone a long way to proving that humans do not make fully rational, optimal decisions under risk due to a number of these cognitive biases. 

Simply put, the Disposition Effect is the tendency of traders to hold on to positions that have decreased in value, while selling assets that have increased in value. It is a persistent effect that can be observed in almost any dataset of trading activity. The effect was identified in a 1985 paper by Hersh Shefrin and Meir Statman titled: The Disposition to Sell Winners Too Early and Ride Losers Too Long: Theory and Evidence. 

Prospect Theory

The underlying causes for these strange choices in behaviour were identified by Daniel Kahneman and Amos Tversky in 1979 under the name of Prospect Theory, which shows that human beings are inherently risk-seeking in the negative domain and risk averse in the positive domain. In other words, they will take more risk to avoid a loss than they will to secure a gain. 

When asked whether they would rather have a guaranteed $3000 or an 80% chance of receiving $4000, 80% of Kahneman and Tversky’s subjects chose the certainty of $3000, which makes complete sense. 

Where it gets strange, however, is that when asked whether they would rather have an 80% chance of losing $4000 over a certain loss of $3000, an overwhelming 92% of the group chose the 20% chance of avoiding the $4000 loss over the definite loss of $3000.

The paper that presents this phenomenon was titled: Prospect Theory: An Analysis of Decision Under Risk. It’s still by far the most cited paper ever published in the journal Econometrica and was one of the reasons Kahneman was awarded the Nobel Prize in Economics in 2002.

The insights of Prospect Theory go a long way to explaining the Disposition Effect because Kahneman and Tversky demonstrated that human beings are not rational utility maximisers as assumed by classical economics. Rather, they have an asymmetrical, and fundamentally irrational way of making decisions under risk as demonstrated by the way they’re naturally wired to prioritise avoiding losses rather than making gains. 

Some Armchair Evolutionary Speculation

Now, if you consider it a little, you can probably reason for yourself why it seems we’re hard-wired to prioritise avoiding loss rather than securing gain. In our evolutionary past there was much more at stake than just money when it came to loss. Loss in the evolutionary sense means death and the inability to pass on your genes, so it makes sense to be highly conservative when it comes to loss. 

In this way, you can also understand why so many traders fall prey to the Disposition Effect. We’re not really designed to deal with the bewildering abundance of data and ambiguous feedback that markets provide us with. Furthermore, consider that a losing trade is only a losing trade when you cash out of it. So, a position could be bleeding money for months before a trader starts to “feel” the loss and is forced to do something about it. You can’t say the same thing about bleeding in nature, which is a loss that is immediate and actively contributing to your death with each passing second. 

It also goes some way to explaining why traders keep cutting their winners rather than letting them run. The old saying goes: “A bird in the hand is worth two in the bush.” In other words, the certainty of booking a small profit now is preferred over waiting for a large profit later that may never come. Grab what you can now, because the future isn’t guaranteed. 

Where Social Trading Comes In 

Call it social trading, mirror trading, or copy trading; outsourcing the opening and closing of positions to someone with more experience than you should be a no-brainer, right?  But how does this financial innovation stack up against the Disposition Effect in practice? 

As we saw above, investment professionals seem to be just as vulnerable to the Disposition Effect as are less experienced traders and market newcomers. As a market professional you live and die by your track record, so it’s understandable why professionals who should really know better also succumb to the Disposition Effect. John Nofsinger has characterised this kind of behaviour as arising out a desire to avoid regret and seek pride.

A 2016 study by Heimer titled Peer Pressure: Social Interaction and the Disposition Effect  showed that investment-related social media actually caused the Disposition Effect to increase in traders. The difference here is that Heimer’s study looked at trading-specific social networks, not social trading venues. You can think of it as all the chatter around markets without anything really being on the line, so to speak. No “skin in the game,” as Nassim Taleb would put it.

Interestingly, a new study by Danbolt, Eshraghi & Lukas, published in 2021, reveals that in a social trading environment where copy traders are provided accurate information about the performance of trade leader portfolios, the Disposition Effect diminished by around 35%. This is a highly significant finding if it can be replicated. 

The data used in the experiment was provided by a European social trading platform, with trading behaviour and performance being compared between portfolios whose performance was publicly visible versus portfolios that were kept private. The public portfolios were demonstrated to be significantly less prone to the Disposition Effect than the private ones.

This makes intuitive sense on one level, without a method of verifying that people are who they say they are, then anyone can pose as an experienced portfolio manager. What’s most interesting about the findings, though, is that they suggest that transparency in social trading platforms contributes to an environment where better trading decisions are made and where cognitive biases such as the Disposition Effect may be reduced. 

It would be fascinating to see follow-up studies that look at other cognitive biases too, or that try to pin down the reason why trading performance improves when portfolios are public. Our suggestion is that when traders are competing against each other in a fair and transparent manner, then those who are less prone to the Disposition Effect will naturally rise to the top. 

About Cooma

For us these findings are a small confirmation that we’ve been going about social trading in the right way. We envisioned Cooma as a place where market newcomers can come to learn the ropes without going it alone, and where experienced traders who have paid their dues in markets can earn a living by sharing their trades. From the outset, we have ensured that all performance stats pertaining to trade leaders are fully-audited, that trade copiers are able to select from a host of different risk styles, and that they can also have some control over the process by setting their own stop-loss levels. Come and have a look for yourselves!