Investment novices and professionals alike are subject to the disposition effect. As much as we like to feel logical and rational, we make many decisions driven by fear, pride, and misconceptions. At the most basic level, we can all probably agree that it feels good to win and it feels bad to lose. So, if we are given the chance between winning and losing, our response seems obvious and intuitive.

However, smart decision-making and sound financial performance must be grounded in a comprehensive, holistic point of view rather than an outlook of one-off wins and losses. A keen investor would cut their losing assets over selling assets that will likely continue “winning.” By succumbing to the disposition effect, we risk reducing our long-term returns by holding onto assets with poor future prospects while prematurely selling assets that could have continued appreciating

Taxation and the disposition effect

Taxation policies add another layer to the disposition effect — increasing the cost of this cognitive bias. In many tax systems, like the US, short-term gains are taxed at a higher rate than long-term gains, incentivizing investors to hold onto winning stocks longer.¹ Conversely, realizing losses earlier may allow for tax-loss harvesting, which can offset taxable gains. All in all, avoiding “disposition investing” is a win-win: fewer losses and fewer taxes.

Our reluctance to sell losing investments affects our individual financial standings. However, if many people are prone to the same decision-making behavior, this trend can have a global impact. So, how does the disposition effect come into play at the group level?

Disposition effect on the institutional scale

On a larger scale, the disposition effect can harm institutional investors, including mutual funds, by reducing long-term portfolio performance. Research by Singal and Xu found that over 2,300 active mutual funds exhibited strong disposition tendencies to underperform their peers by 4-6% per year and were less likely to survive over a five-year period. Additionally, the widespread reluctance to sell losing stocks can contribute to broader market inefficiencies, delaying price corrections and reinforcing momentum trading patterns.

Whereas approximately 85% of the non-disposition-prone funds survive after a 5-year period, only 77% of the disposition-prone funds survive. The higher rate of failure suggests that, over a reasonable period of time, these funds are likely to disappear unless they eliminate their disposition orientation.

Sunk cost fallacy 

While the disposition effect applies specifically to financial decision-making, it aligns with a broader cognitive bias known as the sunk cost fallacy — the tendency to continue investing resources into failing ventures due to past commitments. For example, the Denver Airport overspent billions on an ineffective baggage system, and President Johnson escalated U.S. involvement in the Vietnam War despite negative outcomes. Both illustrate how decision-makers struggle to cut losses, a pattern seen in investing as well.

The rationale behind the disposition effect has been widely discussed in behavioral science, yet it boils down to concepts at the core of our behavior. First, let’s break down the process through Daniel Kahneman and Amos Tversky’s prospect theory.

Prospect theory and loss aversion

Kahneman and Tversky saw that in situations of risk or uncertainty, the classical utility theory seemed not to apply. Utility theory suggests that rational individuals will make choices based on the option which gives them the most satisfaction.⁴ With prospect theory, Kahneman and Tversky proposed an alternative decision-making model that reflects unexpected choices in the face of certainty versus uncertainty and loss versus gain.⁵

Kahneman uses the following scenarios to illustrate key points of prospect theory:⁶

For Problem 1, most people would choose to get $900. We prefer certainty over a gamble when it comes to gains. Plus, the idea of not getting anything at all feels much more unpleasant given the potential winnings. For Problem 2, most people would choose to gamble. In this case, the idea of losing $1000 isn’t that much more unpleasant than losing $900. Here we can see the difference in how we approach gains versus losses: we are generally risk-averse with gains and risk-seeking with losses.

Let’s look at one more scenario. Someone asks if you’d like to gamble on a coin toss:

• Tails = You lose $100
• Heads = You make $150

In this scenario, many people wouldn’t take the gamble even though the expected value is in your favor. The possibility of losing $100 is painful enough that it causes most to refuse the toss. This demonstrates our loss aversion. We will often do anything to avoid losses, even if the loss is the best of bad outcomes. Loss aversion could be an evolutionarily beneficial trait. If we are more averse to negative events than positive, we are more likely to avoid danger and survive.⁷

So, within a prospect theory framework, the disposition effect makes a lot of sense:

• We are risk-averse with our gains → We want to cash out on our winners
• We are averse to losses → We resist realizing our losses
• We are risk-seeking when it comes to losses → We hold on to our losses, risking losing more money in order to turn out a win

Mental Accounting

While we may manage physical accounts for our finances, we also often keep intangible mental accounts. Mental accounting causes us to view each investment in isolation and to make our decisions based on the state of the account at hand.8 We also attach emotions to these accounts. Consider the following scenario:

You bought a concert ticket for 60$. It’s the day of the concert, and you realize your ticket has gone missing and you have no proof of purchase. In your mental account, you have already spent the money to attend this concert and already had positive emotions attached to it. So, you may find it easier to reconcile buying another ticket and attending the concert because the negative emotions of spending 60$ for nothing seems worse than paying $120 in total.

In this case, we can see how mental accounts yield irrational decision-making. The same thing happens with the disposition effect. Investors open mental accounts when they purchase stocks and have trouble “closing” these mental accounts at a loss. As a result, they are more likely to ride the losers too long. This “geteven-itis disease,” as referred to by economist Leroy Gross, is a major detriment to financial performance.⁹

Regret and Pride

Other driving forces for the disposition effect are fear of regret and feelings of pride. Fear of regret is powerful. The disposition effect echoes many regret anxieties. What if we sell a losing stock right before it takes off? What if I don’t sell this winner, and it drops? Additionally, the draw of “winning” and the pride that comes with it are major forces for the disposition effect. However, evidence shows that selling your losers and holding on to your winners, at least for a short while, is a better overall decision-making policy to take. So, fear not and try not to let pride get in your way.

Cognitive Dissonance 

Finally, cognitive dissonance may reinforce the disposition effect by making investors reluctant to admit mistakes. Selling a losing stock creates mental discomfort because it forces investors to acknowledge poor decisions, conflicting with their self-image as rational or skilled traders. To avoid this discomfort, they rationalize holding onto the stock, hoping for a recovery. At the same time, selling a winning stock feels like a success, making it easier to justify premature selling. 

Money matters. And so does financial literacy. The better we are at managing our financial portfolios, whether it be a small number of personal stocks or a global portfolio, the more chance we have of building wealth.  

For the general public, the disposition effect influences how they manage their savings, investments, and household financial decisions. Imagine you’re saving for a house deposit or your child’s college. You buy some stocks and shares, hoping they will grow over time and help you reach your goal faster than a standard savings account. However, as the stock market fluctuates, you might feel tempted to sell your winning stocks too soon to lock in small gains—seeking the satisfaction of a win and fearing the possibility of a drop. As a result, you miss out on larger profits and suffer bigger losses, slowing down your saving progress.

The disposition effect can make it harder to achieve financial goals, heavily impacting important life events such as buying a home, funding education, or building a retirement fund. This kind of financial setback can cause significant stress and anxiety, potentially impacting a person’s mental well-being. Understanding this bias helps people make smarter investment choices, stay focused on long-term growth rather than small gains, improve their financial security, and ultimately achieve their life goals. 

The disposition effect not only affects individual investors but also has wider market implications. When many investors exhibit the disposition effect, it can lead to market inefficiencies, price distortions, and increased volatility. If many investors consistently sell rising stocks early and hold onto declining ones, this behavior can create short-term price distortions—leading to underpricing of high-performing stocks and overpricing of poor performers. Over time, these patterns may contribute to market volatility and delay the correction of misvalued assets.

This is one bias that can truly be dampened through awareness of its pitfalls. Understanding how letting go of losers and holding on to winners ultimately benefits us long-term can incentivize us to unlearn our costly disposition. If we can understand this in the realm of investments, we can bring this knowledge to other areas of our personal and professional lives: projects, relationships, and more.

So, what can we do to prevent the disposition effect from causing us to make poor decisions and poor investments? Simply, the answer is to stop holding on to losing investments for too long and selling winners too soon. But that is easier said than done, so we can walk through a cognitive mechanism that helps facilitate this.

Broad framing

One tool is broad framing, or trying to view our decisions in the scheme of the many financial decisions we make rather than in isolation. Here’s an excerpt of Kahneman’s “sermon” on broad framing from his book Thinking Fast and Slow:

“You will do yourself a large financial favor if you are able to see each of these gambles as a part of a bundle of small gambles and rehearse the mantra that will get you significantly closer to economic rationality: you win a few, you lose a few.”10

This quote is worth internalizing. Broad framing is a tool that experienced traders use to fight the emotional reactions surrounding gain and loss.

Setting investment goals and learning about investing 

Research also shows that implementing investment goals and visualizing performance portfolios can reduce or reverse the disposition effect.15 In a study conducted by researchers at the Otto Beisheim School of Management in Germany, participants traded six different stocks over 14 periods in a simulated market with randomized price movements. They were divided into four groups: (1) a control group, (2) a goal-setting group, (3) a group shown a portfolio performance graph, and (4) a group with both goal-setting and performance visualization. The study measured how often participants sold winning vs. losing stocks to determine the impact of these interventions on the disposition effect.

The investors who were given a clear financial target (e.g., reaching $11,000 by the end of the trading period) exhibited a reversed disposition effect. This larger goal encouraged them to focus on their long-term performance rather than reacting emotionally to short-term gains or losses. Similarly, providing investors with a graph that showed their total portfolio performance helped shift their focus from individual stock gains/losses to overall wealth accumulation. Although this intervention alone did not significantly reduce the disposition effect, it was effective when combined with financial goal setting. 

In their pivotal 1985 paper, economists Hersh Shefrin and Meir Statman wanted to further explore loss aversion behaviors as explained in Kahneman and Tversky’s prospect theory.¹¹ Prospect theory explained why people “sell winners too early and ride losers too long,” but Shefrin and Statman noticed that there was only controlled experimental data as support. They felt it was necessary to use data from a market setting to accurately investigate this behavioral pattern.

Shefrin and Statman proposed the disposition effect as a positive theory (meaning a framework that describes or explains economic phenomena) for trends of “gain and loss realization.” They saw that the disposition effect was known between investors, but never addressed in classic economic frameworks. Thus, Shefrin and Statman first situated the disposition effect within the frameworks of prospect theory, mental accounting, regret aversion, self-control, and tax considerations. They then went on to use empirical market data to prove their theory.

Their work ushered in research on the varying applications of the disposition effect within the financial market. And importantly, it named one of the most widespread trends in individual investing. Over the years, research on the disposition effect has shifted from why it happens to how it can be mitigated to enhance financial portfolio performance. 

Researchers have also found evidence of the reverse disposition effect, the tendency for investors to sell losing stocks too soon and hold onto winning stocks for too long. Instead of avoiding realized losses, investors, in this case, cut their losses quickly and let their winning stocks run, often driven by strategies like momentum investing or risk aversion.¹⁸

The disposition effect primarily refers to financial decision-making, especially concerning stocks. However, we can map the core ideas from the disposition effect onto how people manage physical products, especially in retail or inventory-based businesses. The same psychological reluctance to realize losses and preference for locking in gains can influence how business owners price, stock, and sell their inventory.

Imagine the following scenario. Emma owns a small electronics store that sells smartphones, laptops, and accessories. A few months ago, she invested heavily in a new tablet brand, expecting it to become a best-seller after hearing news of its success in other countries. However, demand for the product has been low, and a newer, more popular model has since been released.

Emma hesitates to discount the underperforming tablets because doing so would mean admitting she made a bad investment — a textbook example of loss aversion. She clings to the belief that these tablets will rebound in popularity, much like investors hold onto losing stocks in the hope they’ll recover. Meanwhile, Emma’s storage costs increase, and she misses the chance to stock newer, more in-demand products.

On the flip side, her quick sale of a hot laptop line is driven by the desire to lock in gains — she wants to avoid the regret of missing a high point in prices. But this gain-locking instinct backfires in a retail context, leading to missed opportunities and customer churn.

As a result of her tablet and laptop decisions, her business suffers from higher costs, outdated inventory, and lost revenue, all because the disposition effect influenced her pricing and stocking decisions.

In product strategy, this bias can result in inefficient inventory decisions, sunk-cost-driven product launches, or pricing rigidity. Whether it’s a product manager refusing to sunset a failed feature or a small business owner overvaluing obsolete stock, the disposition effect can quietly erode performance across a product’s life cycle. Businesses that hold onto underperforming assets, such as outdated technology or excess inventory, may incur higher investment costs, ultimately leading to higher consumer prices. The disposition effect also contributes to inefficient pricing strategies, as companies may hesitate to lower prices on unpopular products, believing demand will recover. 

The disposition effect occurs due to human emotions, like fear and regret, and cognitive biases that impact human decision-making. AI algorithms can help reduce this effect by making decisions based on data, not emotions. AI-driven systems don’t feel regret or excitement; that is, they follow logical strategies rather than reacting emotionally. This can improve investment returns and make markets more efficient. 

Researchers from the Norges Bank in Norway conducted a study to understand whether algorithmic traders exhibit the disposition effect in the same way as their human counterparts.¹⁴ Also known as “algotrading,” algorithmic trading is a method of using advanced mathematical models to make transaction decisions in financial markets. In the study, the researchers compared human and algorithmic trading behavior using data from NASDAQ Copenhagen Stock Exchange and uncovered stark differences. 

The human traders realized 28% of their gains (sold winning stocks) but only 17% of their losses (held onto losing stocks). In other words, they mostly held onto their losing stocks instead of selling them. This resulted in an 11.5 percentage point (pp) gap, indicating a strong disposition effect. Even after controlling for factors like transaction costs, portfolio rebalancing, and trading frequency, the disposition effect persisted. In contrast, the algorithmic traders realized 34% of their gains and 33% of their losses, leading to a small and statistically insignificant 1.5 pp gap. This finding suggests that algorithmic traders do not systematically sell winners more than losers, avoiding the bias driven by emotions and cognitive errors.

Overall, the study found causal evidence of the link between human psychology and the disposition effect. In turn, the authors also suggested that since algorithms don’t suffer from emotional biases, they may contribute to more rational market behavior.

So, how do algorithms avoid the disposition effect? Well, unlike human traders who make quick, high-pressure decisions, AI developers have the time to carefully design and refine their decision-making processes. By following a deliberate, systematic approach, developers can eliminate behavioral biases, heuristics, and emotional influences that often lead to irrational trading. This structured programming helps algorithms avoid common cognitive traps, such as attachment to reference points and loss aversion (key drivers of prospect theory) which are believed to explain the disposition effect.

In 2016, financial researcher Rawley Heimer conducted a study exploring the relationship between the disposition effect and peer pressure.¹² The rise of “investment-specific social networks,” such as MyfxBook, enables traders to digitally communicate, track, and compare trading records. Heimer analyzed data from MyfxBook to measure the disposition effect in traders before and after joining trading social networks.

Heimer found significant evidence that social interactions amplify the disposition effect, nearly doubling its impact on trading decisions. He attributes this to the desire for a positive self-image, as traders seek to showcase successful trades while avoiding the embarrassment of admitting losses. Additionally, the public nature of trading records may encourage riskier behavior, as individuals feel pressure to conform to group norms or prove their competence. Echo chambers and herd behavior can further reinforce these tendencies by amplifying social validation, confirmation bias, and collective risk-taking, leading to less rational decision-making.

Heimer’s research highlights the psychological and social factors shaping investment behavior in the digital age. As more traders engage in social investing platforms, understanding these behavioral biases becomes crucial for improving trading strategies, financial education, and platform design to mitigate negative effects.

Economists Stefan Muhl and Tõnn Talpsepp investigated how different market behaviors impact how investors learn to improve to avoid the disposition effect.¹³ Market trends are characterized by “bull markets” (prices on the rise) and “bear markets” (prices receding).

They analyzed data from the Estonian stock exchange from 2004 to 2006 and found that the disposition effect was apparent in both bull and bear markets, but stronger during bear markets. These results match intuition: investors would be more apt to sell their winners if the market declined out of fear of all-around losses. However, they also found that investors learned the most from the disposition effect during bear markets, which they attributed to “harsher financial consequences at such times.”⁹

Previous studies suggest that the impact of the disposition effect also varies across stock markets in different countries. A study of the influence of the disposition effect on stock price momentum across markets in Argentina, Brazil, Chile, and Mexico found significant variations in how it manifests.¹⁶ While the disposition effect is particularly strong in Mexico, it has no significant momentum effect in Argentina. The authors found that the strength of the disposition effect varies across markets and countries due to factors such as investor behavior, market conditions, and reference point anchoring. Another study, this time involving data from 387,993 traders across 83 countries, also found significant variations in the effect of the disposition effect across geographic regions.¹⁹ 

What it is

The disposition effect is our tendency to sell winning assets too early and hold on to losing assets for too long.

Why it happens

This effect is motivated by loss aversion, meaning our resistance to realizing losses even if it is a more profitable move. The disposition effect is also strengthened by keeping mental accounts, seeking pride, and fear of regret.

Example 1 -  How social pressures can impact the disposition effect

A 2016 study by Rawley Heimer showed that investment social networking caused an increase in the disposition effect in traders. Heimer attributes this to the desire for a positive self-image.

Example 2 - How market trends influence the disposition effect

In a research study, Stefan Muhl and Tõnn Talpsepp found that the disposition effect is stronger in a bear market than a bull market. Also, investors learn more from the disposition effect in a bear market.

How to avoid it

We can avoid the disposition effect by practicing broad framing, meaning viewing all decisions comprehensively.

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