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The disposition effect

Many love to win and hate to lose, but when this notion is transferred to investing it can have a detrimental impact on the performance of an individual’s portfolio.

What is the disposition effect?

The disposition effect is defined as the tendency of investors to hold assets that are decreasing in value (the losers) too long and sell the assets that are gaining value (the winners) too soon.

Investors are willing to realise, or cash in, their gains but are more reluctant to realise their losses. To the average person this attitude makes sense; you have made a decision and taken a risk with your money, you want to see that risk pay off. But from a finance perspective this behaviour is somewhat irrational; the decision to sell or hold a particular asset should be based on the perceived future value of that security, not the price you paid for it.

Four ways to combat emotion when investing

Focus on your final wealth level

According to a paper published in the Journal of Finance people evaluate their investments in terms of gains and losses and not the final wealth level. This is intrinsically linked to an individual’s attitude to risk. If an individual is risk averse and has seen an asset gain in value, they are more likely to sell. Conversely, if they are more comfortable with risk they may be liable to hold a stock that has decreased in value in the hope that it might gain.

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By making an investment, your capital is at risk.

In 1998 Odean published a paper that found that the average return of prior winners that investors sell is 3.4% higher, over the next year, than the average return of the prior losers that they hold on to.

There are also tax benefits to recognising losses as these can be offset against any gains making the £11,300 capital gains tax allowance go further.

There have been studies that show that the disposition effect is more evident in individuals with a lower understanding of investing and this is unsurprising. It is not easy for an individual to go against their psychology.

Find out what type of investor you are

Consider a discretionary manager

Behavioural finance is a crucial pillar of what defines Moneyfarm. We use this in our customer profiling to ensure we match individuals to the risk profile that is right for them. Since we offer discretionary wealth management a team of experts rebalances your portfolio on your behalf. This is based on market events and the perceived future value of an asset. Provided you do not let the disposition effect apply to your entire portfolio the team will work to protect and grow your wealth in the long term.

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