Why do we tend to hold on to losing investments?

The Disposition Effect

, explained.
Bias

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

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
  14. Liaudinskas, K. (2022). Human vs. machine: Disposition effect among algorithmic and human day traders, Working Paper, No. 6/2022, ISBN 978-82-8379-235-5, Norges Bank, Oslo 
  15. Seidens, S., &  Wierzbitzki, M. (2018).The Causal Influence of Investment Goals on the Disposition Effect. https://ssrn.com/abstract=3275998
  16. Abinzano, I., Muga, L., & Santamaria, R. (2010). The role of over-reaction and the disposition effect in explaining momentum in Latin American emerging markets. Investigación Económica, vol. LXIX, 273, 151-186. 
  17. Schatzmann, J. E., & Haslhoder, B. (2020). Exploring investor behavior in Bitcoin: a study of the disposition effect. Springer Nature. https://arxiv.org/pdf/2010.12415
  18. Breitmayer, B., Hasso, T., & Pelster, M. (2020). Culture and the disposition effect. Economics Letters. https://arxiv.org/pdf/1908.11492
  19. Guenther, B., & Lordan, G. (2023). When the disposition effect proves to be rational: Experimental evidence from professional traders. Frontiers in Psychology, 14:1091922. doi: 10.3389/fpsyg.2023.1091922

About the Author

Dr. Lauren Braithwaite

Dr. Lauren Braithwaite

Dr. Lauren Braithwaite is a Social and Behaviour Change Design and Partnerships consultant working in the international development sector. Lauren has worked with education programmes in Afghanistan, Australia, Mexico, and Rwanda, and from 2017–2019 she was Artistic Director of the Afghan Women’s Orchestra. Lauren earned her PhD in Education and MSc in Musicology from the University of Oxford, and her BA in Music from the University of Cambridge. When she’s not putting pen to paper, Lauren enjoys running marathons and spending time with her two dogs.

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