When it comes to investing, experience usually means better results… when we learn from our mistakes.
So it’s reasonable to expect experienced traders to be better at what they do. More experience should mean fewer mistakes and better outcomes.
We’ve talked about common behavioral biases before. Let’s take a closer look at the biggest mistake rookie traders make… it’s called “the disposition effect”.
What’s the disposition effect? It’s the tendency for investors to sell– or “dispose” of stocks as soon as they start to increase in price… while holding onto losing stocks and hoping they’ll recover.
But this behavior doesn’t make sense. Why would an investor want to get rid of a stock that’s starting to move higher when it’s behaving like the next big winner? And why would they hold on to the losers that are hurting their portfolio’s value.
Because the fear of losing a profit and an aversion to “cutting their losses” by selling their losers makes rational people behave irrationally.
The prospect theory tells us that traders get fixated on a point of reference… the purchase price. Anything above that price is too tempting to pass up. So they sell and allow their fears to dictate their trading decisions.
They tell themselves, “You can’t lose money taking a profit, right?” So they capture their small gain by selling. And now they’ve made a few dollars… but they may have missed out on big profits by selling too soon.
Just look at shares of Apple Inc. (APPL). If you’d bought back in November 2011, you could have purchased as low as $363.57-a-share. A month later, the stock was up to $406.53.
Time to get out? Plenty of people thought so. And why not? You made money, right?
But Apple kept climbing. If you had just waited your Apple shares would have soared to $626.23 – more than a $250-per-share profit. Still think selling was the right move?
Well, we didn’t have a crystal ball and now all we have is the benefit of hindsight. It’s easy to look back and say that those who sold early made a regrettable mistake.
But at the time those who sold early were thinking “a gain is a gain”. Better to win a little than lose big. People fear loss so much that they’re willing to settle for a slight gain… as long as it’s a gain.
In fact, fear of losses is MORE motivating to traders than gains. Just look at this chart that studied the behaviors and reactions of traders. Without a disciplined plan most traders will settle for a small profit than take the risk of it turning into a loss.
As it clearly shows, traders are more concerned about avoiding losses than they are about letting their profitable trades move higher. Fear of losing trumps the joy of winning repeatedly.
That’s the other side of the disposition effect – losing money on a stock is so unacceptable that traders will hold on to it as long as they can because it just has to come back up… or so they think.
For a simple example of this, all we have to do is think back to the dotcom crash. People lost – and lost BIG – because they wouldn’t respond unemotionally and cut their losses. Instead, they convinced themselves that things would get better… and they rode those hopes all the way to the bottom.
None of us are immune from the blind spots and irrational emotions that impact trading decisions. We’re all vulnerable and at risk.
In fact, most of us have made these exact mistakes more often then we care to remember.
But there are things you can do to protect yourself from being a victim of the disposition effect.
What can you do? For rookie traders, one key is to keep trading.
Studies show that the more experience you have trading, even if you lose money more often than you make money, the more you learn about what to do… and what not to do.
And this only applies to traders who have access to good information. The ones who don’t? They get overwhelmed and they quit trying.
The bottom line is that determined rookie traders will make mistakes. Often, they’ll make lots of them.
And they’ll keep making mistakes until they learn what they’re doing wrong and start making better choices… and that’s when they start making money more consistently.
So what can eager-to-succeed yet inexperienced traders do to speed up the learning process?
The key is to stop making mistakes early on… learn to focus on the right information and resources sooner rather than later.
Stop letting your emotions control your trading and focus on using a system that’s designed to help you make the hard choices when they need to be made.
Easier said than done, right? Not if you know where to look.
Stop selling winners too soon, and holding on to losers for too long by overruling our emotions, gut feelings, rumors and hunches… and start using reliable, unemotional data and a rational strategy.
Using tools like TradeStops will help you accomplish that. You can determine ahead of time when to buy, when to hold, and when to sell… all right at your fingertips.
Track every trade… and take a good, hard look at what works and what doesn’t. Figure out what you want from trading, what you’re comfortable with, and how much you’re willing to risk.
Stop wasting time and money learning by trial and error. Make smart, thoughtful choices now, no matter what your level of experience, and start making trading decisions that lead to better, more consistent results.
That’s what we had in mind when we designed and tested TradeStops. Try it risk-free for 30 days and see what it’s like to be able to cut your losers as quickly as possible and “let your winners run”.
Protection from our blind spots, emotions, and unacceptable losses is worth a fortune. Give yourself that protection and see how TradeStops can work for you!