Whether you dabble in trading yourself or you're surrounded by friends that like to invest in the stock market or into cryptocurrencies, you might have heard that sometimes both crypto and retail investors tend to sell winners and hold on to losers into their portfolios.
You probably think, "no biggie, it's just a fluke," but you'd be surprised to know that we're actually talking about a behavioral anomaly called the disposition effect.
Suppose you're planning to invest in some play-to-earn crypto games, stablecoins, or any other cryptocurrencies. In that case, we advise you to read this article first and get up to speed with the crypto disposition effect and how to avoid falling for it.
What is the crypto disposition effect?
The disposition effect was coined in 1985 by two scholars from the field of behavioural finance named Hersh Shefrin and Meir Statman. They discovered an anomaly that prevents investors from exiting a losing position early or holding on to a winning position for longer.
Simply put, individual investors have a tendency to sell winners too early and ride losers for far too long. Investors typically make possible gains faster by selling assets that have increased value and try to avoid unrealized losses by keeping assets with decreased value longer than necessary.
To further understand the disposition effect and how it works with crypto stock, we must understand concepts like risk or loss aversion, prospect theory, and expected utility.
Risk aversion is a concept that describes the behavior of investors that prefer to preserve their capital over a higher-return investment with greater risks. Most traders avoid taking any financial risk but lose money anyway by holding on to crypto assets for far longer than they should.
Expected utility is utilized as a method to analyze situations when people must make decisions without understanding the potential consequences, or decision making under uncertainty. These people will opt for the course of action that maximizes expected utility, which is the product of probability and utility over all feasible possibilities. In other words, people tend to make rational decisions.
This theory explains why people favor choices that could result in gains and avoid those that could realize losses. For example, if a person had to decide between the following two possibilities:
- To win $1,000 or nothing at all 50% of the time.
- Have a 100 percent chance of earning $500.
People tend to disproportionately favor the second option because it has a guaranteed victory rate, even though the economic result of both alternatives is nearly similar.
How the disposition effect works
If we apply the things we've learned to cryptocurrency trading, we'll see that investors will find it easier to exit at a guaranteed profit than to risk their portfolio for a higher profit once they have established a position in a cryptocurrency. Another example would be people that refuse to work overtime or higher-paying jobs for fear of paying more money in taxes.
The disposition effect constitutes one of the most significant challenges for day traders and investors. It stands in the way of capital efficiency and prevents most traders from making optimal trading decisions.
Positive disposition effect
The market exhibits a usual positive disposition effect during bearish periods, selling winners way too quickly. If we take the disposition impact into consideration, we'll see most traders will likely sell assets instead of keeping them in this situation.
This applies to both the stock market and the cryptocurrency market.
Reverse disposition effect
During bullish periods, on the other hand, the market demonstrates a reverse disposition effect, where traders and investors tend to hold their position way too long. When left to their own devices, they don't sell assets that are losing value, refusing to accept that they have already lost money.
Disposition effect examples
The crypto disposition effect or disposition impact can explain, for example, why many cryptocurrency investors bought Bitcoin back in 2021, well below its peak, and have kept it and continue trading it even after it fell by 70%. This is just one instance from the Bitcoin ecosystem.
In another case, it explains why few (or possibly none) traders were able to profit from Shiba Inu's explosive 25 million percent gain in 2021 because they sold way too early.
How to avoid the crypto disposition effect
Let's take a step back and look at the bigger picture, and see how we can correct the crypto disposition effect. For instance, it is proven that during periods of extreme volatility, people will sell a loser faster than they would during relatively calm periods.
However, there are various tactics you may use to increase your chances of exiting positions at a more rational time, no matter what market trend the Bitcoin cryptocurrency market exhibits.
Ask any day trader, and they will admit that they manage their trades on a case-by-case basis. While when done correctly, this can be highly effective, it frequently leads traders to place too much stock in the results of a single deal.
This may give the transaction outcome more weight than it deserves. In fact, that single trade is a minor component of a broader scheme.
That's where broad framing comes into play. Looking at the bigger picture allows you to grasp the goal of your crypto assets investment strategy. The aim is to achieve an overall profitable gain rather than focus on smaller ones with the same amount of money.
If you look at your investments from this perspective, it will be easier to continue trading without making rash decisions.
It's easy to guess what could be an investor's worst enemy. His own emotions!
Traders become irrationally or emotionally connected to their cryptocurrencies instead of following their investment strategies. It can be challenging to overcome, but it can be made much easier by consciously eliminating emotion from the process through automation.
Using limit orders to automatically exit your positions at a predetermined price based on current analyses is the simplest way to do this. This can involve placing a stop-limit order for fundamentally weak holdings in a downtrend, while you might think about a take-profit order for fundamentally strong ones in an uptrend. Using limit orders, you won't be tempted to sell your winning positions too soon, not the opposite.
As human beings, we give remarkable advice, but we hardly ever follow them ourselves. However, you'll discover that some abstraction is much needed when it comes to financial economics and price manipulation.
If you ever find yourself holding on to a coin with zero chances of increasing its value, remember these behavioral biases and take a moment to assess the situation. Is it clear that the coin's trading volume and value will continue plummeting? Are you holding on just because you're avoiding acknowledging your losses? If the answer is yes, what would you tell a friend in your position?
The answer to that last question is the advice you should also follow for yourself. Abstraction finds evidence where emotion fails to do so.
We hope you liked our incursion into the fascinating world of behavioural finance, and we're leaving you with a better understanding of the disposition effect and how to avoid it in order not to lose money.
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