The disposition effect in behavioural finance is one of the many biases or partialities that people are influenced by when they make imperfect decisions, particularly in investing and market trading.
The disposition effect describes how investors often sell shares whose price has risen when they might be holding them in hopes of higher gains. To an extent the investor ‘taking profits’ is logical and healthy.
However, selling after a short time to avoid possible future loss can deny the investor financial gain.
Trying to be rational all the time
Rather than admit failure, or through sheer inertia, investors with the disposition effect neglect the shares and let them tread water indefinitely.
Rationally, it is best to sell these poorly performing items before they decline further and then re-invest the proceeds in fresh, researched, ventures with the expectation of making money.
The rational and emotional reactions that make investors practise the disposition effect has much in common with another bias, ‘loss aversion’.
As with the disposition effect, this bias says that people don’t wish to risk loss, even though they might acquire equivalent gains. They feel it is better not to lose £5 than to find £5 even though both are actually the same.
This is not so surprising as psychological studies have shown that people feel losses twice as much as they feel gains. Investors want to avoid losses at all costs, so they exhibit risky behaviour by holding onto duff shares.
They are loss averse, so they sell shares too soon before they even begin to show signs of further upward movement.
Disposition Effect is centre stage for investors
Cognitive and social psychology academics Nicholas Barberis and Wei Xiong describe the disposition effect as one of “the most robust facts about the trading of individual investors.”
They say the disposition effect is common in individual investor trading and is linked to pricing phenomena, such as post earnings announcement ‘drift’, and stock level momentum.
This bias also extends to the real estate market, where properties that don’t sell hang around for months or years when common sense would dictate in that in many cases the seller should reduce the price and sell.
Prospect theory and aversion bias
This brings us to Daniel Kahneman and Amos Tversky’s ‘prospect theory’ of 1979.
People hate to lose. Losing, we learn, is much more of an emotional event than gaining, to such an extent that people prefer not to risk gaining for fear of losing face and being disappointed.
Professor Barberis, has noted: “Stocks that have done well over the past six months tend to keep doing well over the next six months; and that stocks that have done poorly …… tend to keep doing poorly over the next six months.”
Why is the disposition effect so strong that investors keep doing the exact opposite of what they should do – sell the poor shares and keep the good ones?
Why do investors think the odds don't apply to them? Source Shutterstock.
Barberis and others have come up with some queries for the investors irrational behaviour. For example active investors are often outperformed by passive, longer term investors. What is the significance of this?
Why, he asks, do buyers think they know something the seller doesn’t? Why do investors think the odds don’t apply to them? Why do they think they are the exception to the apparently obvious rule? Why are they so confident?
The culpable bias – over confidence
A lot of bias boils down to the problem of over confidence. Kahneman and Tversky reckon that over confidence is a big culprit in making poor assessments. In other words, a lot of us believe the glass is half full and will stay that way, but often neither of these things fit the facts.
A mental solution to the problem does exist. It is called ‘hedonic framing’ which may be worth a try. The idea is that the person or investor fools their prejudices by making themselves think of a single, large gain as parcels of small gains, and to think of small losses as a single, large loss.
Also this solution suggests that people might think in terms of parcelling up different-sized losses into a more attractive net minor gain.