Why the “Disposition Effect” Makes You Sell Winners and Hold Losers
The irrational fear of “locking in a loss” will cost you money.
In this article, we’ll cover the disposition effect, one of the most common habits I see among new investors.
Author’s Note: This article is part of my series on investing psychology:
12 Common Mistakes That Can Destroy Your Investing Profits
Learn how successful investors avoid cognitive traps and build a winning mindset.
The Disposition Effect — What is it?
The disposition effect is the tendency of investors to hold onto assets that have lost value and sell assets that have gained value.
How does the disposition effect apply to investing?
Imagine an investor buys two stocks in his portfolio, one of which quickly goes down by -25% and the other quickly goes up 25%. The investor will happily sell the 25% gainer and marvel at his profits, but he holds onto the 25% loser, hoping it will “come back up.”
His decision to hold the loser stems not from a thoughtful strategy or analysis, but because the investor doesn’t want to experience the emotional pain of realizing a nasty loss on his stock.
So, rather than sell the position and allocate his funds to another stock, he holds on until the loss becomes small (or becomes a gain), at which point he can sell without feeling badly.
Not only is this type of bias driven by emotion rather than strategy, but a well-established investing style suggests investors should actually do the opposite!
Momentum investing shows that winning stocks tend to keep winning, while losing stocks tend to keep losing.
So if the investor were to make any trading decision on his two stocks based solely on their percent return, the rational investor should hold his winner and sell his loser.
That said, I wouldn’t recommend making trading decisions based on your percentage gain.
There’s a better way.
What should you do instead?
Every time you trade you should ask yourself:
“Is this the best possible stock I can allocate my money to?”
The answer to that question should drive most of your buy / sell / hold decisions.
The amount your personal investment in the stock has gained or lost is pretty much irrelevant as to whether something is a good investment going forward.
Here’s a classic example:
Imagine you bought General Electric (GE) right as it began its slow and painful march towards a nearly -80% decline.
Rather than hold on and wait for it to come back up (so it doesn’t feel bad to realize a loss) you should ask yourself, “Is GE still the best possible place to allocate my money?”
If so, then definitely keep it!
If not, then take the loss and allocate your money to something better.
The money you invested has already shrunk by nearly -80%. Leaving it in GE or selling out and allocating it elsewhere doesn’t change the fact that every dollar invested is now only 20 cents.
The ultimate example of the disposition effect is an investor who would rather hold onto a losing stock until it gains 20% back to where he bought it (breakeven) than take the loss and allocate the money to a stock that gains 30% over the same time period.
Clearly, the 30% gain is much better! But by waiting for his losing position to return to breakeven, he can avoid the pain of “locking in a loss.”
This idea of “locking in a loss” is an illusion. The loss has already happened, regardless of the trading decision he makes.
The disposition effect is driven by “loss aversion,” which I cover in detail here:
Disclaimer: This article is provided for informational or educational purposes only and is not any form of individualized advice. All information is obtained from sources believed to be reliable but cannot be guaranteed for accuracy or completeness. Use this information at your own risk.