What is the disposition effect?
The disposition effect is the tendency of investors to sell investments that have risen too early, and to hold on to investments that have fallen for too long. It was named by the economists Hersh Shefrin and Meir Statman in 1985, and it has since been documented among private and professional investors in many countries.
It works against good results: selling winners locks in small gains, while holding losers leaves the portfolio full of the investments that performed worst.
Where it comes from
- Avoiding regret: selling at a loss makes the loss final and admits a mistake; holding on keeps the hope of a recovery alive.
- Loss aversion: according to prospect theory, people feel a loss roughly twice as strongly as a gain of the same size.
- Anchoring to the purchase price: the price paid feels like the "right" value to get back to, although the market has no memory of it.
How it is measured
Researchers compare how readily investors sell their winners and their losers. On every day an investor sells something, each position counts as a realized gain or loss if it was sold, and as a paper gain or loss if it was kept:
A proportion of gains realized (PGR) above the proportion of losses realized (PLR) indicates a disposition effect. In classic studies of US brokerage accounts, investors realized gains about one and a half times as readily as losses.
A simple illustration
On the days an investor made sales during a year, their positions showed 20 gains and 20 losses in total. They sold 8 of the winning positions and 2 of the losing ones:
The investor was four times as likely to sell a winner as a loser.
What it costs
- Returns: research has found that the winners investors sold went on to outperform the losers they kept.
- Taxes: in many tax systems realized losses can offset gains; holding losers while selling winners does the opposite.
- Weak holdings pile up: over time the portfolio fills with the positions that performed worst.
How to counter it
- Judge each position as if it were a new purchase, ignoring the price paid.
- Follow rules decided in advance, such as rebalancing to target weights.
- Review realized and unrealized gains together to see whether sales systematically favour winners.
Related topics
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