In April of 1998 I bought 300 shares of Apple Computer (NASDAQ:AAPL) at $1.00/share (split adjusted). My reasoning was simple: I bought a new Mac a few months earlier and immediately realized that this was the future of computers. The ease, simplicity and intuitive technology was head and shoulders above any PC I had ever owned.
In May of 2000, as the Nasdaq was beginning its epic technology plunge, I sold those shares for $3.20/share, more than tripling my money and in so doing, making myself (in my mind) master of the universe. Those shares that I so astutely sold in 2000, are now trading at over $100. No, I never bought them back. Ever.
My handling of Apple shares is a perfect illustration of, "The Disposition Effect," the individual investor's single most pervasive impediment to investment success. Succinctly put, the disposition effect describes the tendency to avoid actions that create regret and seek actions that cause pride. It was my desire for pride, tripling my money in about three years, that I allowed to overshadow my reason for buying the shares in the first place: That Apple was cutting edge technology and a glimpse into what a true visionary, Steve Jobs, had in store for the technology revolution. With the introduction of the first iPhone in June of 2007, when AAPL was still under $20/share, the dynamic future of both the company and the share price had finally arrived. From June, 2007 through to March, 2015, AAPL's share price rose from $15 to $135, trading today at just over $100.
It was my avoidance of regret, of admitting I made a bad decision when I sold the shares at $3.20, that prevented me from buying back into AAPL. Another nuance of the disposition effect: Investors often regret the actions they take, but seldom regret the ones they do not.
The disposition effect manifests most commonly through the tendency for investors to take profits too early and hold losses too long. This is the reverse of what has been distilled into a Wall Street adage: "Let your profits run and cut your losses short." If left unabated the disposition effect sabotages long term investment success. It is just the way we are wired. In my case, it wasn't that I held a loss too long, but it was the same concept, i.e. staying flat the shares and stubbornly refusing to buy back in as the company was still at the beginning of its ten-bagger destined future.
So what does a long term investor do? First, get control of the evil investment twins of fear and greed, the very heart of the disposition effect. One simple and easily implemented guiding principle can remove emotion, fear, greed, and the disposition effect out of trading decisions: USE STOPS! This rule may not tell you when to get in, but it will tell you when to get out, but maybe most important all, it tells you when to stay in.
First, let's deal with the concept of gratification, the pride of holding a winner in your portfolio. If you need to feel good about those early gains, go ahead and take some profits off the table and bank them. But so long as your investment thesis still stands, i.e., the reason you have bought the stock in the first place is still operative, whether fundamental or technical, keep most of the position in play. Some pride is realized, but the shares left untouched and in play keep you still in the game.
Because there is no such thing as a free lunch, the strategy of taking early and quick profits is not without some downside. By taking a profit, a capital gain is realized, and we all know that with a capital gain, comes taxes.
On the other side of the ledger, when price turns down from the start, there is less wiggle room. Simply put, if you buy a stock and it goes down, you have made a wrong decision. Accept it, own it, but don't let it rattle you. Now,"going down," doesn't mean a quarter of a point in a day, but it has to mean something, it has to be defined. In my case, I draw trend lines and channels for my stops, and if the stock breaks down below those trend lines or channels, breaks what I consider key support, I am out, no questions asked.
Trend lines and price channels are not the only one way to objectively define when a stop is hit and the trade is over. Simple arithmetic provides perhaps the easiest way to establish a stop. Setting a percentage loss, 5%, 8%, 10%, or any reasonable measure of loss works as well. Before entering a trade, decide ahead of time at what point a negative return indicates that your decision to buy was wrong. Use that price level as the stop that closes the position. If the stock hits it, exit the trade with again, no questions asked. Stops only work if they are obeyed, and they are most effectively obeyed if they are entered at the same the trade is established. "Mental stops," are just another way of saying, "maybe I'll close the trade, maybe not," which itself is another way of saying, "maybe I'll make money in the stock market, maybe not."
The disposition effect is a form of cognitive dissonance that limits gains and allows losses to run, the exact opposite of letting profits run and cutting losses short. Such a simple concept, yet one so underused and underestimated on the road to trading success. Making money in the stock market is hard enough without the need to psyche ourselves into holding losses, or prematurely exiting wins. Master the disposition effect, and you master yourself, your investment decisions, and your success as an investor.
Examples of Using Trend Lines To Overcome The Disposition Effect
Note above how there was no reason to sell AAPL all the way up from the 2009 lows, i.e., the trend channel contained price all of the way up.
Facebook (NASDAQ:FB) has been going up virtually from its IPO in May of 2012.
Notice on the Disney (NYSE:DIS) chart how often price came to rest right on the trend regression channel lines before resuming its primary trend.
Two primary trends in Silver over the past 18 months. Price remains in a rising channel through early August with no sign of weakness.
From March through September of 2015, Mobileye (NYSE:MBLY) was in a nicely contained uptrend channel, rising in price from approximately $40 to $65. In the mini-crash of mid-August, 2015, the stock fell hard (along with the rest of the market) breaking through the lower trend channel at about $55. Price tried to get back into the channel, but failed, then put in another leg down into the mid-20's by the end of the year. No matter how bright a future MBLY may have had in August of 2015, using a logically placed stop avoided being caught in the price carnage to follow.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.