What is the disposition effect?
The disposition effect refers to our tendency to prematurely sell assets that have made financial gains, while holding on to assets that are losing money. We are driven to sell our winning investments in order to ensure a profit, but are averse to selling losing investments in hopes of turning them into gains.
Where it occurs
Imagine that you need money to finance your upcoming summer travel plans. You are looking at your investment portfolio to decide what financial moves to make, so that you can have the lavish vacation of your dreams.
You narrow it down to selling shares of two different companies. Let’s call them Company A and Company B. Company A is up in value from where you purchased it. Company B is at a lower standing than the price you bought in at. Their prices have both been relatively stable in the past few weeks. Selling stock in either company would set you up in a solid spot financially for your travels. So, which do you sell: Company A or Company B?
You think to yourself, “Well, it would be nice to go out with a win for Company A. Also, maybe Company B will turn around in my favor in the future…I think I’ll hold onto it for a bit longer.” You decide to sell Company A, chalk it up to a win on your record, and go on your way. However, you continue to incur losses on Company B.
Like many individual investors, you have fallen into the enticing trap of the disposition effect: cashing in on gains before realizing your losses.
Investment novices and professionals alike are privy to the disposition effect. As much as we like to feel logical and rational, we make many decisions driven by fear, pride, and misconceptions. At the most basic level, we can all probably agree that it feels good to win and it feels bad to lose. So if we are given the chance between winning and losing, our response seems obvious and intuitive.
However, smart decision-making and good financial performance must be grounded in a comprehensive point of view, rather than an outlook of one-off wins and losses. A keen investor would cut their losing assets over selling assets that will likely continue “winning”. By succumbing to the disposition effect, we are incurring more losses and fewer gains in the long-term.
Taxation policies also increase the costs of the disposition effect. This is another important incentive for us to re-examine how we approach losses and gains. Tax rates differentiate between short term gains/losses and long term gains/losses, with long term rates at about half of the short term.1 Consequently, it is more profitable to realize our losses in the short term because it will result in a lower tax burden. All in all, avoiding “disposition investing” is a win-win: fewer losses and fewer taxes.
Our reluctance to sell losing investments affects our individual financial standings. However, if large numbers of people are prone to the same decision-making behavior, this trend can have a global impact. So, how does the disposition effect come into play on the group level?
On the level of an investment firm, selling winners early and losers late will incur major long term losses for the group. Finance researchers Vijay Singal and Zhaojin Xu examined the extent of the disposition effect at over 2,300 active mutual funds, and the overall performances of these mutual funds. They found that, on average, “disposition-prone” mutual funds fall behind non-disposition-prone funds by 4-6% each year.2 They also found that disposition-prone funds are less likely to survive. Singal and Xu state:
Whereas approximately 85% of the non-disposition-prone funds survive after a 5-year period, only 77% of the disposition-prone funds survive. The higher rate of failure suggests that, over a reasonable period of time, these funds are likely to disappear unless they eliminate their disposition orientation.
These results show how the disposition effect can determine whether a firm sinks, or swims.
While the disposition effect originated in the context of investing, the behavioral pattern of holding on to losing investments in hopes for a gain can be found in a variety of contexts. For example, in 1990 the Denver Airport went 2 years and $2 billion over budget to implement a new strategy for baggage handling.3 Even the Vietnam War, where President Johnson continued to send troops and resources despite negative outcomes, can serve as an example of our disposition to continue investing in losses.
This effect also aligns with the sunk cost fallacy, our tendency to continue funneling resources, be it time, money, or material, towards a losing investment.
Why it happens
The rationale behind the disposition effect has been widely discussed in behavioral science, yet it boils down to concepts at the core of our behavior. First, let’s break down the process through Daniel Kahneman and Amos Tversky’s prospect theory.
Prospect theory and loss aversion
Kahneman and Tversky saw that in situations of risk or uncertainty, the classical utility theory seemed not to apply. Utility theory suggests that rational individuals will make choices based on the option which gives them the most satisfaction.4 With prospect theory, Kahneman and Tversky proposed an alternative decision-making model that reflects unexpected choices in the face of certainty versus uncertainty and loss versus gain.5
Kahneman uses the following scenarios to illustrate key points of prospect theory:
“Problem 1: Which do you choose?
Get $900 for sure OR 90% chance to get $1000
Problem 2: Which do you choose?
Lose $900 for sure OR 90% chance to lose $1000”
For Problem 1, most people would choose to get $900. We prefer certainty over a gamble when it comes to gains. Plus, the idea of not getting anything at all feels much more unpleasant given the potential winnings. For Problem 2, most people would choose to gamble. In this case, the idea of losing $1000 isn’t that much more unpleasant than losing $900. Here we can see the difference in how we approach gains versus losses: we are generally risk-averse with gains and risk-seeking with losses.
Let’s look at one more scenario. Someone asks if you’d like to gamble on a coin toss:
Tails = You lose $100
Heads = You make $150
In this scenario, many people wouldn’t take the gamble even though the expected value is in your favor. The possibility of losing $100 is painful enough that it causes most to refuse the toss. This demonstrates our loss aversion. We will often do anything to avoid losses, even if the loss is the best of bad outcomes. Loss aversion could be an evolutionarily beneficial trait. If we are more averse to negative events than positive, we are more likely to avoid danger and survive.
So within a prospect theory framework, the disposition effect makes a lot of sense:
- We are risk-averse with our gains → We want to cash out on our winners
- We are averse to losses → We resist realizing our losses
- We are risk-seeking when it comes to losses → We hold on to our losses, risking losing more money in order to turn out a win
While we may manage physical accounts for our finances, we also often keep intangible mental accounts. Mental accounting causes us to view each investment in isolation and to make our decisions based on the state of the account at hand.8 We also attach emotions to these accounts. Consider the following scenario:
You bought a concert ticket for 60$. It’s the day of the concert and you realize your ticket has gone missing and you have no proof of purchase. In your mental account, you have already spent the money to attend this concert, and already had positive emotions attached to it. So, you decide to buy another ticket and attend the concert because the negative emotions of spending the $60 for nothing seem worse than paying $120 in total.
In this case, we can see how mental accounts yield irrational decision making. The same thing happens with the disposition effect. Investors open mental accounts when they purchase stocks and have trouble closing these mental accounts at a loss. As a result, they are more likely to ride the losers too long. This “geteven-itis disease”, as referred to by economist Leroy Gross, is a major detriment to financial performance.9
Regret and Pride
Other driving forces for the disposition effect are fear of regret and desire for pride. Fear of regret is powerful. The disposition effect echoes many regret anxieties. What if we sell a losing stock right before it takes off? What if I don’t sell this winner and it drops? Additionally, the draw of “winning” and the pride that comes with it are major forces for the disposition effect. However, evidence shows that selling your losers and holding on to your winners, at least for a short while, is a better overall decision-making policy to take. So, fear not and try not to let pride get in your way.
Why it is important
This is one bias that can truly be dampened through awareness of its pitfalls. Understanding how letting go of losers and holding on to winners ultimately benefits us long-term can incentivize us to unlearn our costly disposition. If we can understand this in the realm of investments, we can bring this knowledge to other areas of our personal and professional lives: projects, relationships, and more.
How to avoid it
So what can we do to prevent the disposition effect from causing us to make poor decisions and poor investments? Simply, the answer is to stop holding on to losing investments for too long and selling winners too soon. But that is easier said than done, so we can walk through a cognitive mechanism that helps facilitate this.
One tool is broad framing, or, trying to view our decisions in the scheme of the many financial decisions we make rather than in isolation. Here’s an excerpt of Kahneman’s “sermon” on broad framing from his book Thinking Fast and Slow:
“You will do yourself a large financial favor if you are able to see each of these gambles as a part of a bundle of small gambles and rehearse the mantra that will get you significantly closer to economic rationality: you win a few, you lose a few”
This quote is worth internalizing. Broadframing is a tool that experienced traders use to fight the emotional reactions surrounding gain and loss.
How it all started
In their pivotal 1985 paper, economists Hersh Shefrin and Meir Statman wanted to further explore loss aversion behaviors discussed by Kahneman and Tversky’s prospect theory. Prospect theory explained why people “sell winners too early and ride losers too long”, but Shefrin and Statman noticed that there was only controlled experimental data as support. They felt it was necessary to use data from a market setting to accurately investigate this behavioral pattern.
Shefrin and Statman proposed the disposition effect as a positive theory (meaning a framework that describes or explains economic phenomena) for trends of “gain and loss realization”. They saw that the disposition effect was known between investors, but never addressed in classic economic frameworks. Thus, Shefrin and Statman first situated the disposition effect within the frameworks of prospect theory, mental accounting, regret aversion, self-control, and tax considerations (as previously discussed. They then went on to use empirical market data to prove their theory.
Their work ushered in research on the varying applications of the disposition effect within the financial market. And importantly, it gave name to one of the most widespread trends in individual investing.
Example 1 – Social pressures
In 2016, financial researcher Rawley Heimer conducted a study exploring the relationship between the disposition effect and peer pressure.12 The rise of “investment-specific social networks”, such as myfxBook, enables traders to digitally communicate, track, and compare trading records. Heimer analyzed data from myfxBook to measure the disposition effect in traders before and after joining trading social networks.
Heimer found significant evidence that social interactions increase the disposition effect, stating the effect was almost doubled. He attributes this to the desire for positive self-image among other social mechanisms.
Example 2 – Market trends
Economists Stefan Muhl and Tõnn Talpsepp investigated how different market behaviors impact how investors learn to improve their response from the disposition effect.13 Market trends are characterized by “bull markets” (prices on the rise) and “bear markets” (prices receding).
They analyzed data from the Estonian stock exchange from 2004 to 2006 and found that the disposition effect was apparent in both bull and bear markets, but stronger during bear markets. These results match intuition: investors would be more apt to sell their winners if the market was in decline out of fear of all-around losses. However, they also found that investors learned the most from the disposition effect during bear markets, which they attributed to “harsher financial consequences at such times”.
What it is
The disposition effect is our tendency to sell winning assets too early and hold on to losing assets for too long.
Why it happens
This effect is motivated by loss aversion, meaning our resistance to realizing losses even if it is a more profitable move. The disposition effect is also strengthened by keeping mental accounts, seeking pride, and fear of regret.
Example 1 – How social pressures can impact the disposition effect
A 2016 study by Rawley Heimer showed that investment social networking caused an increase in the disposition effect in traders. Heimer attributes this to the desire for a positive self-image.
Example 2 – How market trends influence the disposition effect
In a research study, Stefan Muhl and Tõnn Talpsepp found that the disposition effect is stronger in a bear market than a bull market. Also, investors learn more from the disposition effect in a bear market.
How to avoid it
We can avoid the disposition effect by practicing broad framing, meaning viewing all decisions comprehensively.