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The term “the disposition effect” was first introduced by Hersh Shefrin and Meir Statman in their 1985 work that referred to investors’ inclination to sell winners too soon and hold onto losers for an excessively long period.
The disposition effect may have affected you if you’ve liquidated a position way too early despite the considerable upward potential that retained an asset with virtually no chance of recovering.
The disposition effect usually hinders capital efficiency and does not allow investors to make the best trading decisions, which is one of the biggest problems investors face today.
Let’s learn more about this effect, in detail, in this blog!
Crypto disposition effect: In detail
The disposition effect is the propensity of investors to keep assets that are losing value (the losers) for an excessively long time and to sell assets that are growing in value (the winners) for an excessively short period of time. For example, selling stocks on the stock market is the typical way of disposition.
Individual investors are eager to take advantage of or cash in on gains, but they are less keen to admit losses. This attitude seems reasonable to the normal person since you have already made a decision and taken a financial risk, and you want to see the results of that risk.
However, from a financial standpoint, this behavior is pretty unreasonable. It will help if you make a decision on the basis of holding or selling a particular asset on your investment’s expected future worth and not the price you paid for it.
To understand this effect better, the following examples can be helpful.
Disposition effect examples
Example 1. Assume a stock in ABC was purchased by an investor in their general investment account for $1000 three months ago, and it is currently trading at $750. The investor must choose whether to sell the stock at a loss or hold onto it. Both are available to the investor.
- Selling the ABC stock will result in a $250 loss.
- Keep the ABC shares since there is a 50/50 possibility of breaking even or losing more money ($250).
Based on the disposition effect: The investor is more inclined to hold onto the ABC shares than to suffer a loss. Conversely, when a loss occurs, risk-taking behavior increases.
Example 2. If Crypto was purchased for $10,000 by an investor five years ago, and now its value is $40,000. The investor must choose whether to sell the Crypto for a profit or hold onto it for their portfolio. Both are available to the investor.
- Sell the Crypto and get $30,000 in profit.
- The possibility of gaining additional money ($30,000) is 50/50; therefore, keep the Crypto stock.
Based on the disposition effect: The investor is more inclined to sell the Crypto than to hold it, according to the disposition effect. When presented with profit, some people exhibit the selling winners’ behavior.
Example 3. A day trader lost 35% of their initial investments. The investor has two choices.
- Stop trading for the current day and start the following day again.
- Continue trading; there is a 50/50 probability that deals placed in the afternoon will break even or result in losses.
Based on the disposition effect: The day trader is more inclined to continue trading than to accept a loss for the day.
These examples must have given you a fair idea of this Crypto disposition effect. Let’s check how you can avoid this situation from occurring.
How can you avoid the Crypto disposition effect?
Unfortunately, most traders tend to manually quit their positions at the wrong time or too early when they are left to their own devices.
The disposition effect is deeply ingrained in human nature, making correction challenging but not impossible. Nevertheless, you can use various strategies to give yourself the best opportunity of getting out of positions at a more reasonable time. One of them is explained below.
If you’re anything like the majority of traders, you probably manage your trades individually. While when done correctly, this can be highly effective, it frequently leads traders to place too much faith in the results of a single deal.
This may give the transaction outcome more weight than it deserves. When in fact, the trade is a minor component of a broader plan.
You may view it for what it truly is — just a part of the plan — if you turn the paradigm on its head and instead concentrate on the greater picture. This method is referred to as broad framing.
Your Crypto investment approach aims to generate a sizable total profit rather than concentrating on several smaller ones.
By taking this perspective on your finances, you might be less likely to make snap decisions.Disclaimer: Cryptocurrency is not a legal tender and is currently unregulated. Kindly ensure that you undertake sufficient risk assessment when trading cryptocurrencies as they are often subject to high price volatility. The information provided in this section doesn't represent any investment advice or WazirX's official position. WazirX reserves the right in its sole discretion to amend or change this blog post at any time and for any reasons without prior notice.