Chris WhealThe disposition effect is when an investor, or investors, hold on to losing stocks too long and sell winning stocks too soon. It is based on fear of making losses.
Investors have a well-performing stock that has increased in value. They know it has made them a healthily profit but they don’t know how long that rise is going to last and fear it might have reached a peak and be about to fall.
So they sell, despite the evidence suggesting that the rise will continue. They convince themselves that a good run has to end. This is partly another theory called ‘Reversion to the mean’ – that prices end up (fall or bounce back) at the average over time.
Bottom of the cycle
Conversely, investors have a stock that has nosedived. They know they have made a loss so do not want to sell before it recovers, despite there being no evidence it will recover.
They would be embarrassed to admit – to themselves as much as anybody – that they got it wrong. So they hold that stock in the hope it will bounce back.
The disposition effect is counter to evidence or analysis, not a deliberate tax decision (to establish a loss that can be offset against later gains) and not deliberate rebalancing. Investors and economists consider it irrational behaviour. Psychologists are less critical.
History lesson
The disposition effect was identified in a 1995 paper in the American Finance Association’s hugely influential Journal of Finance, written by Hersh Shefrin and Meir Statman. It was titled: The Disposition to Sell WInners Too Early and Ride Losers Too Long: Theory and Evidence.
Four main characteristics were identified that collectively became known as the disposition effect:
- Prospect theory
- Mental accounting
- Seeking pride and avoiding regret
- Self-control
Prospect theory
Prospect theory covers how humans consider the value of gains and losses when considering a risk, rather than the final outcome they expect from taking the risk. The theory was first developed in 1979 and reworked in 1992. It involves a complex mathematic formula.
In simple terms we each view a calculated outcome differently. For example, if the potential loss is £1,000 some may view that as trifling, others as catastrophic, with many differing responses in between.
Our individual reference points influence our decision and what we consider to be a success or failure and how we feel about them. But the key is that, in general, if we make a loss or gain of the same magnitude, the loss feels bigger than the gain – as much as 50% bigger.
Mental accounting
There’s an example used by modern-day financial psychologist Kim Stephenson: turning up to a major event – a concert or sporting final – only to discover you have lost your expensive means of entrance.
In both cases you can afford the £120 entrance, and tickets remain available.
- In scenario 1 you had a £120 ticket bought in advance, put in your pocket that morning but discovered it missing, lost or stolen
- In Scenario 2 you had the £120 in your pocket to buy entrance on the door but discovered it missing
Many people would buy a ticket in scenario 2 and enjoy the event but not in scenario 1.
This is because they have an allocation in their mind – a mental account – for tickets, and that money is spent. With no money left in that mental account they cannot afford to buy a new ticket.
In the disposition effect a loss-making stock is in a separate mental account, not part of an overall portfolio as part of an investment strategy with a combined performance. It is making a loss and cannot be closed until it returns to profit.
Seeking pride and avoiding regret
Seeking pride and avoiding regret are two sides of the same coin. We all want to boast of our successes, even if we only boast to ourselves. We feel better for them, more confident.
We similarly wish to avoid regret. This can result in us repeating actions taken in the past that were successful, avoiding risk or deciding to stick with what we have.
If we make a mistake, we believe a decision to do something is more of a mistaken decision than a decision to do nothing.
Self-control
Shefrin and Statman state that reluctance to realise loss stems from a lack of self-control over negative emotions and feelings of guilt.
The combination of these factors can result in investors selling while stocks rise and holding them while they fall.
Enough investors exhibit this behaviour to make a noticeable impact on share prices. Markets have failed to respond as positively as expected to good news because so many sell too early.
How to beat the disposition effect
Stephenson points out that we cannot rid ourselves completely of specific biases – and, if we did, others would replace them. He also makes clear that as individuals, how we respond varies.
Kim Stephenson: "it’s your money, you make the decisions."His general advice is to take time to consider why you are investing, how much you need to earn to achieve your goal and over what timescale you are investing.
“One person’s goals would not suit another, so take time to consider (possibly with the aid of significant others) what you actually want your money to do for you.
"After all, it’s your money, you make the decisions, you suffer the anxieties or enjoy the use you make of it. The money is your tool, you’re not the tool of your money – or you shouldn’t be,” Stephenson says.
Focus on what you are trying to achieve in the long term rather than on an individual trade and if you can achieve that with safer investments or trades, why choose riskier ones?
Restrict yourself
Stephenson believes we should ignore ‘risk profiles’. If you don’t need the rate of return that level of risk can bring, don’t take it.
If you don’t need the money in the short term, holding on to investments longer – the way the great investors Warren Buffet and Peter Lynch [link to value investors] do – makes sense.
He also advises record-keeping – detailed books of:
- What trades you made
- Why you made them
- What it would take for you to exit each trade
- How they performed
- What it cost you to do the trade
- Why you exited when you did
Spot patterns. Admit failures to yourself and implement strategies to avoid repeats or set up triggers to warn you if you start repeating your old habits.