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:
“Problem 1: Which do you choose?
Get $900 for sure OR 90% chance to get $1000
Problem 2: Which do you choose?
Lose $900 for sure OR 90% chance to lose $1000” 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 $100 is painful enough that it causes most to refuse the toss. This demonstrates our loss aversion. We will often do anything to avoid losses, even if the loss is the best of bad outcomes. Loss aversion could be an evolutionarily beneficial trait. If we are more averse to negative events than positive, we are more likely to avoid danger and survive.7
So within a prospect theory framework, the disposition effect makes a lot of sense:
- We are risk-averse with our gains → We want to cash out on our winners
- We are averse to losses → We resist realizing our losses
- We are risk-seeking when it comes to losses → We hold on to our losses, risking losing more money in order to turn out a win
While we may manage physical accounts for our finances, we also often keep intangible mental accounts. Mental accounting causes us to view each investment in isolation and to make our decisions based on the state of the account at hand.8 We also attach emotions to these accounts. Consider the following scenario:
You bought a concert ticket for 60$. 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 decide to buy another ticket and attend the concert because the negative emotions of spending the $60 for nothing seem 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 desire for 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.