Disposition effect
The Disposition Effect is a cognitive bias that refers to an investor's tendency to sell assets that have increased in value while keeping assets that have decreased in value. This behavior occurs even when there are no rational grounds for such decisions, often driven by the emotional responses associated with gains and losses.
How it works
The Disposition Effect functions through an emotional response mechanism. When investors see a gain, it triggers a positive emotional response, motivating them to 'lock in' their gains by selling the appreciated asset. Conversely, holding onto a losing asset is often due to the reluctance to realize a loss, as doing so would mean acknowledging a bad decision. The underlying psychological factor is the need to avoid regret and the preference for pride, which can override logical investment decision-making.
Examples
- An investor holds stocks in two companies: Company A and Company B. Over the past year, Company A’s stock value increased by 30%, while Company B’s stock value decreased by 20%. Due to the disposition effect, the investor sells Company A's stock to realize a gain but holds onto Company B's stock in the hope of a rebound, even though the market outlook remains negative for Company B.
- A trader has multiple positions open but closes those that are in profit quickly to 'safeguard' their gains, while letting losing positions run in the expectation that they will eventually recover, contrary to market trends.
Consequences
The Disposition Effect can lead to suboptimal investment portfolios, as keeping losing stocks and selling winners may result in higher risk exposure and reduced overall returns. This bias can cause investors to miss out on significant potential future gains from holding rising stocks and can contribute to poor retirement savings outcomes.
Counteracting
To counteract the Disposition Effect, investors can set predefined rules for buying and selling stocks, such as stop-loss orders to limit losses and investment horizon goals that focus on long-term, data-driven decisions. Educating oneself about psychological biases and incorporating algorithms or third-party management can further help mitigate these emotional biases.
Critiques
Critics argue that the Disposition Effect simplifies a complex behavior, as investors may have legitimate strategic reasons for selling winner stocks and retaining loser ones, such as tax considerations or diversification strategies. Moreover, personal risk tolerance and market conditions can also influence these decisions, complicating the attribution of actions solely to emotional biases.
Fields of Impact
Also known as
Relevant Research
The disposition to sell winners too early and ride losers too long: Theory and evidence
Shefrin, H., & Statman, M. (1985)
The Journal of Finance, 40(3), 777-790
Are investors reluctant to realize their losses?
Odean, T. (1998)
The Journal of Finance, 53(5), 1775-1798
The disposition effect and underreaction to news
Frazzini, A. (2006)
The Journal of Finance, 61(4), 2017-2046
Case Studies
Real-world examples showing how Disposition effect manifests in practice
Context
Miguel, a 34-year-old software engineer, began actively trading through a mobile brokerage app during a market upswing. He monitored his portfolio daily between work sprints and treated small rallies as opportunities to 'lock in wins.'
Situation
Over a 12-month period Miguel repeatedly sold positions that had risen 8–20% to realize quick gains and posted the trades in a private social group. At the same time he left several stocks that had fallen 15–35% untouched, convinced they would rebound because he'd 'buy back in' at a better price.
The Bias in Action
Miguel exhibited the disposition effect by systematically realizing gains early while avoiding realization of losses. Push notifications celebrating profitable trades and social feedback reinforced his inclination to sell winners. Losses were mentally labeled as 'temporary setbacks,' so he held losing positions hoping to avoid admitting a mistake. This behavior was driven by a desire for the psychological reward of winning and an aversion to realizing losses, not by a re-evaluation of fundamentals or portfolio allocation.
Outcome
After 12 months Miguel's portfolio underperformed a simple passive benchmark. He paid higher taxes because many of his realized gains were short-term; meanwhile, several positions remained deep underwater and absorbed capital. The net result was lower after-tax returns and a more concentrated, riskier portfolio than he intended.