The 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.
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
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.
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.