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.
But, the flipside of the disposition effect is even worse. Investors tend to hang on to investments, shares, commodities and the like, when these assets have dropped in value.
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.