Why do we tend to hold on to losing investments?
The Disposition Effect
, explained.What is the disposition effect?
The disposition effect describes our tendency to sell winning investments too early while holding onto losing investments for too long. This behavior is driven by a combination of loss aversion and the hope of potential gains, even at the expense of long-term profitability. This bias can lead to suboptimal investment decisions, reducing overall returns and increasing exposure to risk.
Where it occurs
Imagine that you need money to finance your summer travel plans. You are looking at your investment portfolio to decide what financial moves to make so that you can have the lavish vacation of your dreams.
You narrow it down to selling shares of two different companies. Let’s call them Company A and Company B. Company A is up in value from where you purchased it. Company B is at a lower standing than the price you bought it at. Their prices have both been relatively stable in the past few weeks. Selling stock in either company would set you up in a solid spot financially for your travels. So, which do you sell: Company A or Company B?
You think to yourself, “Well, it would be nice to go out with a win for Company A. Also, maybe Company B will turn around in my favor in the future… I think I’ll hold onto it for a bit longer.” You decide to sell Company A, chalk it up to a win on your record, and go on your way. However, you continue to incur losses on Company B.
Like many individual investors, you have fallen into the enticing trap of the disposition effect: cashing in on gains before realizing your losses.
The disposition effect occurs primarily in financial markets, affecting the trading decisions of private investors, institutional traders, and fund managers. However, it has also been observed in emerging markets like cryptocurrencies. Studies on Bitcoin investors have found evidence of the disposition effect, with its intensity varying over time. During the bitcoin market boom and bust of 2017, for example, the disposition effect became more pronounced, suggesting that market conditions can influence the degree to which investors exhibit the disposition effect.17