The Disposition Effect

Money can be more than a financial resource.  For many of us, money is a way of keeping score.  We use it to gauge our net worth, or to value the skills and experience we offer to employers.  We feel a sense of achievement when we get a raise.  We mark accomplishment by reaching a particular compensation range. And we measure the progress we make to our financial goals with it. 

As investors, money can become a badge of honor we wear when we find success in the financial markets.  Think of any investment you sold after watching it appreciate in value.  It probably felt good to cash out and walk away with a profit.  Scoring a “win” in the markets lends an aura of aptitude.  Maybe you wouldn’t consider yourself an expert but your sudden success helped you believe you could do well as an investor in the future. 

You may not have realized it at the time, but you were under the influence of the disposition effect.  That’s what happens when you sell a winning investment too hastily in order to realize a gain, driven by a desire to secure investment success.  It’s also what happens when you hold a losing investment for too long, in a vain hope its value will change course and turn around… eventually. 

What happens when the disposition effect erodes your investment plan?  When you always sell your winners but hold on to your losers, you end up with a basket of, well, losing investments. Like many habits, understanding the how’s and why’s of the disposition effect can help you lessen its impact on your financial plan.

Knowing when to hold

The causes of the disposition effect are rooted in our tendency for avoiding loss — we hate to lose more than we like to win. This controls both our preferences for selling a winning investment early and scoring an easy victory, and for keeping a losing investment in our portfolios rather than to sell it and admit to a mistake.

Investors tend to look at each holding in their portfolios separately, yet we often choose these investments with the idea that they work together.  When we analyze performance, we often zero in on one investment instead of looking at the performance of our portfolios as a whole.  Remember the reason why proper diversification can work — the whole is greater than the sum of its parts.  The performance of individual positions within a portfolio may ebb and flow, but taken all together over the long term, the cumulative performance is intended to help us to pursue our goals.

More experienced investors know the secret to minimizing the impact the disposition effect.  How an investment has performed in the past — whether it gained in value or declined, whether it is now priced higher or lower than your original investment — is largely irrelevant.  What really matters is how the investment will perform in the future.  Of course, there are tax considerations around selling any holdings, which I’ll discuss later on.  In short, the disposition effect is our tendency as investors to hold on to poor performers too long while predisposed to recognize gains, (often prematurely).  

Will a winning position continue its positive run?  Usually, there are good reasons why winning positions increase in value — there is often something fundamentally positive going on at the company, whether it's strong sales, product innovation, prudent management, or strong cyclical trends in the broader economy.  Naturally, you wouldn’t give up on a company that has prospects for growth and the potential for positive returns.  But investors often do this, just to realize an immediate gain when a stock is performing well.  Of course, there’s no guarantee a winning position will continue to win. But selling an investment only for the ego boost that comes from turning a profit or “locking in a profit” is a tendency of an emotionally charged investor. 

Selling an investment comes down to a decision — will it rise or fall in the future?  Either way, there’s potential for regret: Selling now means you may miss future gains and regret exiting the investment early; Holding the investment means you risk losing what you have earned and regret not taking profits when you had the opportunity. 

Every investment decision offers the potential for regret — there’s no getting around that.  Some psychologists believe we place too much weight on regret — amplifying its effects in advance of making any investment decision.  Perhaps most of all, it’s a sign of an investor who has let emotion override common sense and more disciplined decision-making.  

Knowing when to fold

What about investments that have declined in value?  Investors tend to hang on to their “losers” for too long, believing a rebound is just around the corner. There’s often no basis for this belief, only a wish the investor has to recoup all losses and “get back to even”.  What’s really going on is the investor doesn’t want to admit they’ve made a mistake. Selling a losing investment is to confess to an error in judgment or to a lack of skill or savvy.  Remember, we tend to avoid painful situations.  Holding on to these losers in hope of a turnaround feels better than addressing a shortcoming or poor decision. 

So should you sell a losing investment?  To answer that question, you should ask another — do you believe in the prospects for growth in the future?  If the answer is yes, and it’s based on sound reasoning and an objective review of the facts, then by all means hold on.  But if the answer is no, it may be time to look for a replacement. 

Here’s an exercise that can help you decide:  Let’s say you’ve invested $10,000 in a stock and its price drops 25 percent. Your investment is now worth $,7500.  If you hold on to the stock, you’ll need at least a 33 percent gain on the $7,500 to get back to your original $10,000 investment.  Now, what if you sell this investment after the 25 percent loss and buy another? What return will you need on the replacement stock to recoup your losses?  The answer is the same—33 percent. 

That’s why you should ask which investment has the better prospects for return in the future.  Is it 1) the current investment, or 2) any other investment you can choose from in the marketplace that may be better positioned for growth or more appropriate for your portfolio? 

Does this mean you should always hold on to your winners and sell your losers, countering the disposition effect by doing the opposite?  Not necessarily. Whichever way you look at it, the decisions to buy or hold or sell are still based on past performance.  When faced with these choices, you need to put blinders on to the past.  Whether you buy, sell or hold an investment should depend on what you believe the prospects for gains are for the future and whether it makes sense in light of your current situation, not whether you are presently “up” or “down” on the investment. 

Now, past performance does come into play with losing investments, because our tax laws allow us to reduce taxes on capital gains by realizing capital losses. In these cases, we don’t care anymore about the prospects for growth in the future — we only want to reap the benefits of tax benefits today. Does this nullify the influence of the disposition effect? Not at all. In fact, many taxpayers act irrationally when it comes to tax loss harvesting, most of which is done in December just before the end-of-year deadline.1 Investors have the entire year to harvest their investment losses, yet the vast majority wait 11 months to do so. Procrastination is definitely at work, but so is the psychological tendency we know as the disposition effect.

Conclusion

Investors who are (at least) aware of our tendencies to succumb to the disposition effect are in a good position to avoid its negative impact on portfolio performance. Focus on the future and attempt to be dispassionate to the past when making investment decisions.  Avoid the impulse to sell winning investments and your natural instinct to hold on to the losers.  

Two thoughtful and proactive strategies could lead to better results.  First, you could implement a disciplined, quantitative approach to portfolio decisions.  Second, it would be appropriate to seek independent and objective advice when considering meaningful portfolio changes.  If you need investment experience or an objective second opinion, please do not hesitate to contact us.   

 

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. 

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. 

Diversification does not protect against market risk.

 

1. “Are Investors Reluctant to Realize Their Losses?” Terrence Odean. The Journal of Finance, Vol. LIII, No. 5. October 1998.