Memory and Information Processing Biases

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

Economics & Finance

Psychology & Social Science

Also known as

Loss Aversion Bias

Profit-taking Bias

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

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