Why do we tend to hold on to losing investments?

The Disposition Effect

, explained.
Bias

What is the disposition effect?

The disposition effect refers to our tendency to prematurely sell assets that have made financial gains, while holding on to assets that are losing money. We are driven to sell our winning investments in order to ensure a profit, but are averse to selling losing investments in hopes of turning them into gains.

Where it occurs

Imagine that you need money to finance your upcoming 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 in 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.

Sources

  1. Constantinides, G. M. (1984). Optimal stock trading with personal taxes: Implications for prices and the abnormal January returns. Journal of Financial Economics, 13(1), 65–89. https://doi.org/10.1016/0304-405X(84)90032-1
  2. Singal, V., & Xu, Z. (2011). Selling winners, holding losers: Effect on fund flows and survival of disposition-prone mutual funds. Journal of Banking & Finance, 35(10), 2704–2718. https://doi.org/10.1016/j.jbankfin.2011.02.027
  3. Shefrin, H., & Statman, M. (1985). The Disposition to Sell Winners Too Early and Ride Losers Too Long: Theory and Evidence. The Journal of Finance, 40(3), 777–790. JSTOR. https://doi.org/10.2307/2327802
  4. Briggs, R. A. (2019). Normative Theories of Rational Choice: Expected Utility. In E. N. Zalta (Ed.), The Stanford Encyclopedia of Philosophy (Fall 2019). Metaphysics Research Lab, Stanford University. https://plato.stanford.edu/archives/fall2019/entries/rationality-normative-utility/
  5. Kahneman, D. (2013). Thinking, Fast and Slow (1st Edition). Farrar, Straus and Giroux.
  6. Ibid.
  7. Ibid.
  8. Shefrin & Statman, 1985.
  9. Shefrin & Statman, 1985.
  10. Kahneman, 2013.
  11. Shefrin & Statman, 1985.
  12. Heimer, R. (2016). Peer Pressure: Social Interaction and the Disposition Effect (SSRN Scholarly Paper ID 2517772). Social Science Research Network. https://doi.org/10.2139/ssrn.2517772
  13. Muhl, S., & Talpsepp, T. (2018). Faster learning in troubled times: How market conditions affect the disposition effect. The Quarterly Review of Economics and Finance, 68, 226–236. https://doi.org/10.1016/j.qref.2017.08.002

About the Authors

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Dan Pilat

Dan is a Co-Founder and Managing Director at The Decision Lab. He is a bestselling author of Intention - a book he wrote with Wiley on the mindful application of behavioral science in organizations. Dan has a background in organizational decision making, with a BComm in Decision & Information Systems from McGill University. He has worked on enterprise-level behavioral architecture at TD Securities and BMO Capital Markets, where he advised management on the implementation of systems processing billions of dollars per week. Driven by an appetite for the latest in technology, Dan created a course on business intelligence and lectured at McGill University, and has applied behavioral science to topics such as augmented and virtual reality.

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Dr. Sekoul Krastev

Sekoul is a Co-Founder and Managing Director at The Decision Lab. He is a bestselling author of Intention - a book he wrote with Wiley on the mindful application of behavioral science in organizations. A decision scientist with a PhD in Decision Neuroscience from McGill University, Sekoul's work has been featured in peer-reviewed journals and has been presented at conferences around the world. Sekoul previously advised management on innovation and engagement strategy at The Boston Consulting Group as well as on online media strategy at Google. He has a deep interest in the applications of behavioral science to new technology and has published on these topics in places such as the Huffington Post and Strategy & Business.

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