Social Trading Strategy – research into the disposition effect and how to overcome it

Behavioural biases could be having a big impact on your trading profits. You may have the best social trading strategy but your psychology, or the psychology of traders you copy, could be the barrier to your success.  A behavioural pattern known as the disposition effect is one such bias.

The disposition effect is a behavioural bias that has been studied by many behavioural economists. It happens when investors are quick to take profit on trades that have increased in value while holding on to trades that have dropped in value.

Takeaways

• The disposition effect is the tendency to sell winners too early and hold losers too long, which can have a negative impact on performance.

• Copying another trader will make you feel more confident and knowledgeable but it doesn't guarantee protection from the disposition effect.

• You can maximise the chance of limiting the disposition effect by focusing on which traders you follow.

MIT researcher, Dr. Yaniv Altshuler', found that providing the name of a specific `guru' to copy resulted in 6-10% more earnings when compared with trades made without social networks. The research even found that earnings were 4% more when following a specific 'guru' when compared with unguided copying of a guru who wasn't recommended.

More studies have been conducted to see if this same behaviour is consistent in social trading environments, which have become popular with investors over the last few years.

Social trading involves transparency and group interaction, which is shown to greatly impact our behavioural biases, especially in terms of the disposition effect, which we will now dive into.

What is the disposition effect in social trading strategy?

The disposition effect is a bias in decision-making, which describes the tendency to sell winners too early and hold losers too long. This bias may lead to poor investment decisions because it motivates us to take early profits rather than hold on for more gains.

By definition, social trading brings transparency to an individual's trading performance, including how much money was made or lost on each trade.

This transparency can motivate social traders to secure profits early in hopes of looking better to their peers and moving up the performance leaderboard.

The factors that influence the disposition effect

Age: Older traders are less affected by the disposition effect than younger traders. This is thought to be due to improved skill from years of trading experiences (Dhar and Zhu, 2006). Traders aged between the ages of 20-30 have been shown to display more overconfidence than other age groups.

Gender: The disposition effect is more prominent in men than in women (Da Costa, Mineto and Da Silva, 2008). The study showed that women are quick to exit losing trades due to increased risk aversion.

Education: A study on the disposition effect in the Tehran Stock Exchange found a relationship between the level of education a person has and how much they are affected by the disposition effect (Tehrani and Gharehkoolchian, 2012).

Information: The more information investors gather about their investment, the less they experience the disposition effect. Essentially, they are more confident about their trade, so emotions and behavioural-bias can't take over (Shapira and Venezia, 2001).

The disposition effect in social trading strategy

Social trading platforms track signal providers trading actions in real-time, which results in greater transparency and social interaction. In traditional forms of trading, these potential influencing factors do not exist.

According to an NCBI study, social interaction decreases the disposition effect due to the following factors:

Learning intensity: Social trading increases the desire to learn and improve. In

fact, further studies revealed social traders increase their trading activity, learning participation, and risk level compared with traditional trading (Hong, Kubik and Stein, 2004; Kaustia and Knüpfer, 2012).

Learning quality: Social trading allows users to gain increased knowledge from other traders, which in turn decreases the disposition effect

Public scrutinisation: Social trading gives exposure of trading outcomes to others, which can lead to increased self-consciousness. With all eyes on your performance, you may be more inclined to keep the winners running.

According to another study in the Journal of information technology, interaction and behavioural bias was found to have an impact on trader performance, but not all of it was positive:

Trade duration: In situations where the position is running in a favourable direction, trade duration has a positive impact on trader performance. As soon as it's running in a negative direction, trader performance is no longer positively correlated. This aligns with the previously discussed disposition effect.

The number of traded pairs: The narrower the focus of the trader, the better the performance of the trades. This makes a lot of sense, as a trader who only trades a small number of pairs will be more focused and knowledgeable about the positions, which means they're less influenced by price moving in either direction.

Social following: The more closely followed a trader, the greater the urge is for a trader to avoid losses and protect win ratios. A study found that publicly showing a physician's performance positively influenced their behaviour (Godager, Iversen and Ma, 2015). This suggests that individuals act more carefully when followed/observed, which can result in profits being

secured too early.

What can we learn from the Journal of information technology study?

By copy trading, you are not protected from the disposition effect as the traders you are copying (particularly those with a greater number of followers) are likely to have been affected by the disposition effect themselves.

You can escape the disposition effect by:

TIP 1: Following a mix of traders that each has varying amounts of followers. This will balance out the effects of the disposition effect.

TIP 2: Follow traders with a narrower focus on traded pairs, as there is a positive correlation between a narrower focus on trading pairs and trader performance.

TIP 3: Win ratio alone may not be the best predictor of performance, particularly in traders who have a greater number of followers. Look at other available stats about the trader such as Age, Gender and Experience before following them as the disposition effect could limit theirs and your potential gains.

Conclusion

To conclude, the disposition effect is the tendency to sell winners too early and hold losers too long, which can have a negative impact on performance if not taken into account.

Interestingly, there are conflicting thoughts on the relationship between the disposition effect and social trading strategy. One case shows that social trading increases the willingness to learn and the total amount of knowledge gained.

But while you will be more confident and knowledgeable, copying another trader doesn't guarantee protection from the disposition effect, as the trader being copied is likely to have been affected by the disposition effect themselves.

You can maximise the chance of limiting the disposition effect by following traders with a narrower focus on traded pairs, while also following a mix of traders that each has varying amounts of followers.

References

Dhar, R. and Zhu, N., 2006. Up Close and Personal: Investor Sophistication and the Disposition Effect. Management Science, 52(5), pp.726-729.

Da Costa, N., Mineto, C. and Da Silva, S., 2008. Disposition effect and gender. Applied Economics Letters, 15(6), pp.411-413.

Tehrani, R. and Gharehkoolchian, N., 2012. Factors Affecting the Disposition Effect in Tehran Stock Market. International Business Research, 5(3).

Shapira, Z. and Venezia, I., 2001. Patterns of behavior of professionally managed and independent investors. Journal of Banking & Finance, 25(8), pp.1573-1587.

Hong, H., Kubik, J. and Stein, J., 2004. Social Interaction and Stock-Market Participation. The Journal of Finance, 59(1), pp.137-163.

Kaustia, M. and Knüpfer, S., 2012. Peer performance and stock market entry. Journal of Financial Economics, 104(2), pp.321-338.

Godager, G., Iversen, T. and Ma, C., 2015. Competition, gatekeeping, and health care access. Journal of Health Economics, 39, pp.159-170.