Recent academic studies have confirmed what trend followers have long known: you must have an unemotional sell strategy before you ever enter the market. The NY Times recently ran a good article covering the subject:
Read Article in NY Times from Paul Lim
The academic research on investor selling behavior consistently produces the same finding: the decision of when to sell is more psychologically difficult than the decision of when to buy, produces more systematic errors, and accounts for a larger share of total portfolio performance than most investors recognize. The buy decision is exciting. The sell decision is either painful (admitting a loss) or anxiety-producing (locking in a gain that might continue growing). Both emotional conditions push investors toward the wrong timing.
The disposition effect, documented extensively in behavioral finance research, is the empirical summary of this problem. Investors hold losing positions too long and sell winning positions too early. The holding of losers is driven by the desire to avoid confirming a loss: a position held but not sold has not officially produced a loss. The premature sale of winners is driven by the desire to lock in proof of being right: a profitable position is sold to capture the gain before it can disappear. Both behaviors produce worse outcomes than a systematic exit rule would produce.
The research Paul Lim’s NYT article covers confirms that this is not a behavioral quirk of unsophisticated retail investors. It applies to professional fund managers as well. Studies examining the buy and sell decisions of mutual fund managers found that managers applied significantly more analytical skill to their buy decisions than their sell decisions, and that the securities they sold subsequently outperformed the securities they bought to replace them. The managers were good at identifying opportunities and poor at identifying when to exit them.
Trend following’s structural solution to this problem is the predefined exit rule. The stop loss and trailing stop are not optional risk management features. They are the core of the approach. Every position entered has a defined exit: the 2N stop on the downside, the trailing breakout on the upside. The exit is not a decision made in the presence of the position and all the emotions associated with it. It is a rule defined when the position was entered, when the mind was clear and the emotional associations with the position had not yet formed.
The “before you ever enter the market” framing in the original passage is the key insight. The exit must be defined before entry because the entry creates the emotional relationship with the position that makes the exit decision subject to all the biases the research documents. A trader who has not defined the exit before entering will make the exit decision under emotional conditions. A trader who has defined the exit before entering will execute a rule under emotional conditions. Executing a rule under emotional conditions is consistently more accurate than making a decision under emotional conditions.
The academic research validates what Richard Dennis, Ed Seykota, and every other systematic trend following practitioner built into their approaches from the beginning. The exit rule is not the least important component of a trading system. It is the most psychologically demanding component, which is precisely why it must be removed from real-time human judgment and encoded in advance as a rule.
Frequently Asked Questions
Why must an exit strategy be defined before entering a trade?
Because the act of entering a position creates an emotional relationship with it that makes the exit decision subject to the disposition effect and other behavioral biases. Before entry, the exit criteria can be defined objectively based on system rules. After entry, the loss aversion that comes with a declining position and the anxiety about giving back gains that comes with a winning position both push the exit decision in the wrong direction. Defining the exit before entry removes the decision from the emotional conditions that produce systematic errors.
What is the disposition effect and how does it affect exit timing?
The disposition effect is the empirically documented tendency to hold losing positions too long and sell winning positions too early. It is driven by the desire to avoid confirming losses (which requires exiting the losing position) and the desire to lock in gains (which produces premature exits from winning positions). Systematic trailing stops and defined stop losses counter both directions of the effect by requiring exit when price reaches the defined level regardless of the emotional state associated with the position.
How does the research on professional fund managers relate to individual traders?
It shows that the disposition effect and poor exit timing are not limited to unsophisticated retail investors. Professional managers who applied significant analytical skill to buy decisions made systematically poor sell decisions, and the securities they sold subsequently outperformed their replacements. This means the exit problem is structural, driven by the psychology of owning a position rather than by lack of information or analytical capability. The structural solution is systematic rules, not better analysis.
Trend Following Systems
Want to learn more and start trading trend following systems? Start here.
