Disposition Effect
The disposition effect is the tendency to sell assets that have increased in value while holding assets that have decreased in value, often to avoid realizing losses and the associated regret.
THE IDEA
Foiling Foibles
Suppose a person needs to sell some stock to get the down payment for a house. The person owns two stocks: ABC company, which has done well recently, and XYZ corporation, which has lost money. He sells the ABC stock rather than the XYZ stock because he does not wish to lock in his losses on XYZ by selling it. This illustrates the disposition effect: investors tend to realize gains too early and hold on to losers too long, driven by a desire to avoid regret and the pain of a realized loss.
Another example: Suppose out of the kindness of my heart I give you a hundred dollars. Then I ask you to bet on a coin toss that could result in your either losing that hundred dollars or getting some larger amount of money. The amount that would tip you over into taking the bet is often much higher than $100 due to loss aversion—the psychological principle that losses hurt more than gains feel good.
These are just two of many anomalies that cause us to deviate from rational cost-benefit theory. By recognizing these tendencies, we can arrange our decisions to mitigate their effects and achieve better outcomes.
When to use it
Comparing assets for sale while checking whether reluctance to realize a loss is dominating the decision.
Choosing whether to sell a house that has decreased in value, fearing regret if prices rebound.
Recognizing a related concern about losing security when considering a job change; this is an analogy to loss aversion rather than a direct example of selling winners and keeping losers.
Making everyday decisions where the pain of a loss outweighs the pleasure of an equivalent gain.
FROM THEORY TO EVERYDAY LIFE
In practice
Selling Winning Stock
An investor needs cash for a down payment and owns ABC, which has gained value, and XYZ, which has lost value. They sell ABC chiefly to avoid recording the loss on XYZ. To judge the sale, compare the current alternatives rather than assume the purchase prices determine which asset to keep.
Gambling with Gift Money
As an illustrative choice, imagine receiving $100 and being offered a coin flip that could lose that $100 or produce a gain of $200. Whether you accept depends on how you value the possible outcomes. The amounts do not establish a typical population threshold, and declining alone does not isolate loss aversion.
A MOMENT TO REFLECT
Put it to work.
When have you held onto a losing investment or asset because you didn't want to admit a mistake?
How does the fear of losing a gain affect your willingness to take risks?
Can you think of a situation where you sold a winner too early and regretted it?
Often confused with
CONTINUE THE CONVERSATION
Source texts
- Mindware Tools for Smart Thinking (Richard E. Nisbett)