My life is the complete opposite of everything I want to be – George Costanza
Investing is difficult. It’s a challenge to understand the nuances between asset classes, differentiate among sectors, and choose individual stocks. And, once a choice has been made, it’s easy to second guess our decisions, worry about missed opportunities, and wonder how to maximize returns. The human brain isn’t built to perfectly navigate the world of investing — much unlike homo economicus, the supposedly rational economic actor who can process all available information and always makes perfect decisions. Most humans rely on heuristics to simplify the information we process, and allow emotions to affect our decisions, which in the realm of investment can cause money to be lost and investment portfolios to suffer.
Luckily there are simple ways to navigate investment decisions that can help us outsmart our emotions, allowing us to outperform the market and keep more money in our pockets.
Understanding the Disposition Effect
Among the greatest impediments to our investment performance is the disposition effect, which dictates that the greatest factors influencing our investment decisions are often pride and regret, rather than profit and loss . It refers to the tendency of investors to sell their winning assets too quickly, while holding on to their losing assets for too long.
For example, suppose I buy stock in two different companies, Apple and Microsoft. After a certain period of time Apple’s share price may increase by 5% while Microsoft’s share price decreases 5%. At this point, many investors are prone to sell their shares in Apple. They may do this to realize and protect their financial gain  and to feel the satisfaction and pride of having made a winning investment decision . On the other hand, if an investor were to sell their share of Microsoft, they would have to realize a financial loss (which many people are averse to realizing ), and feel the regret of having made a poor choice . Thus, one holds on to their shares of Microsoft, while selling Apple. Such trading behavior is coined the disposition effect.
Is this wise? Most certainly not. Homo economicus doesn’t care whether his investments are winners or losers. From an investment point of view, there are only two things we should be concerned with: first, we care about the future prospects of the two companies and how the share price reflects those future prospects; second we care about minimizing our tax burden — so if everything else is equal, we would rather sell shares in Microsoft and hold onto shares of Apple.
By selling the loser, we can lock in a capital loss and use that capital loss to pay fewer taxes . Homo economicus would, in fact, display trading behavior that is the opposite to the disposition effect. Humans, however, fall prey to its temptations. Studies [1, 6] have shown that investors are twice as likely to sell their winners (Apple) while holding onto their losers (Microsoft). Why do investors behave this way and what are the consequences of such behavior? Behavioral economics can shed some light on this manner.
Much of the literature on the disposition effect cites prospect theory  to explain such behavior. Prospect Theory suggests that when individuals are faced with decisions that involve judging probabilities and risk, we will often rely upon a reference point to determine whether a specific outcome is a gain or a loss. In turn, individuals (investors) evaluate losses and gains in very different ways. Specifically, losses loom larger than gains (this gap is estimated at roughly 2:1), and people are risk-seeking when evaluating losses but risk-averse when evaluating gains. For example, individuals will be more pained by a $10 loss than they are elated by the joy of a $10 gain. Individuals are also much more likely to gamble on a $10 loss than a $10 gain. Academics who apply prospect theory to investing  suppose that investors use the purchase price of a stock as a reference point. If the stock price goes up, it is considered a winner; if it goes down, it’s a loser. Given that losses loom larger than gains, and how this affects our preferences for risk, an investor will be much more likely to sell a winning investment while holding on to a losing asset.
Okay so this is nice information to know, but one might ask so what, what’s the big deal? Aren’t markets efficient ? At the end of the day does it really matter if I sell Apple and wait to make a decision on Microsoft? Let me just have some fun and realize my winners!
Well not so fast. Studies have shown that investors who are disposition prone  tend to underperform their peers  by as much as 4-6% a year. Not only that, but by selling winners instead of losers investors do not take advantage of a vital component of the benefits of selling losers: paying less tax .
So what can we do to rid ourselves of our disposition behavior and keep more money in our pocket? George Constanza has some sage advice. George, in the last episode of season 5 of ‘Seinfeld’, reflects on his life and that says that ‘it’s just not working …I had so much promise … every instinct I have in every aspect of life … it’s all been wrong’. In reply, Jerry Seinfeld suggests that “if every instinct you have is wrong, then the opposite would have to be right”. Heeding this advice, George resolves to change his behavior, and do the opposite of what his instincts tell him to do. Later in the episode, George fights his shyness, introduces himself to a woman, and bit by bit his life starts changing for the better.
What does this have to do with the disposition effect? The behavioral biases discussed earlier – reference dependence, loss aversion, seeking pride, and avoiding regret – lead us to consistently make inefficient decisions with respect to our investment portfolio. What should we do instead? The exact opposite! That is, hold on to your winners and sell your losers. This type of trading is also known as momentum investing . Momentum investing has been shown to consistently generate above-average returns across different time horizons. Even better, by selling our losers we can lock in capital losses which can be used to pay fewer taxes. It’s a win-win, just like it was for George.
So the next time you’re looking at your portfolio and reflecting on which assets to buy or sell, you may be tempted to sell those winners, brag to your friends about them, and hope against hope that those losers rebound. Or you could think about George Constanza. He benefitted from doing the opposite, and so may you.