I nailed the recent bottom of the market … to the day. Then I made a classic mistake. I took my profits early. Frankly, I couldn’t stand my profits anymore. They just got to be too much for me.

Sounds ridiculous, doesn’t it? Can’t stand my profits? What exactly is going on here?

What’s going on is something that every single market participant needs to understand in order to be successful. Let me explain.

I had bought an S&P 500 futures contract on February 11th, the day when other investors were reportedly lined up around the block buying gold for fear that the bottom of the stock market was about to fall out and we were headed into another recession or worse.

By the morning of March 9th the S&P 500 was up over 9% and I was up 175% on my margin with profits of $8,450 in less than a month. I was very pleased with the trade – proud of myself actually. I had even taken some profits already on a second contract I had purchased around the same time.

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It was pretty easy to talk myself into closing the position. Here are some of the things I suggested to myself:
  • “The markets are looking toppy here. It’s been an incredible run. It’s probably time for a break.”
  • “The futures contract I bought is going to expire in another 10 days or so. It’s probably time to close it out.”
  • “I’m up 175% on my margin. Let’s not get greedy.”

If I could have explicitly stated what was really eating at me, however, it would have gone something like this:

“If this market corrects sharply from here and I lose a big chunk of these profits, I’m really going to feel bad. I’m proud of what I’ve accomplished here. I don’t want to lose it. It’s good enough for me.”

In short, I was avoiding regret. I was afraid that I would regret losing my profits if I didn’t close out the position. That fear of regret outweighed the prospect of even greater profits for me at that point in time and it led me to close out the position.

Over the years I’ve talked a lot about loss aversion – our behavioral bias to want to avoid losses at all costs – and how it leads to us digging holes for ourselves that are very difficult to get out of.

Loss-aversion explains why we tend to hold onto our losers but it doesn’t explain why we have a hard time holding on to our winners.

As humans, we naturally tend to seek actions that will make us proud (like having a successful trade) and avoid actions that will cause regret (like losing our profits). These natural tendencies make us predisposed to hold onto our losers too long and sell our winners too early.

In both cases, we are seeking pride and avoiding regret. We tend to feel regret if we take a loss so we hold onto our losers, seeking the pride of “getting back to break-even” instead. When it comes to letting go of our winners, we take our profits early to capture the pride of success and avoid the regret of giving back our gains.

In 1985, a couple of finance professors – Hersh Shefrin and Meir Statman – published an important paper describing this behavioral tendency. They called it the “disposition effect.”

“Disposition effect” is a really an unfortunate name, in my opinion. It doesn’t mean anything to us when we hear it. We intuitively understand the idea of “loss aversion” but “disposition effect” is just way too academic. I believe that they called it the “disposition effect” because this tendency to seek pride and avoid regret makes us “predisposed” to hold onto our losers and let go of our winners.

Whatever the case, the disposition effect is an absolutely critical behavioral bias that every investor needs to understand at the deepest level. I believe that it is the single most important factor in the chronic underperformance of individual investors. It is certainly what caused me to take my profits early in my recent winning trade.

It’s also a good reminder that even when we know better, like I do, our behavioral biases can still get the better of us. Successful investing requires constant vigilance. We are assaulted every day with way too much information. It makes us jumpy. There are plenty of parties out there who profit from us being jumpy. Unfortunately, you and I are not amongst them.

To your success,

Richard_Signature
Richard M. Smith, PhD
CEO, TradeSmith
Founder, TradeStops.com