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The disposition effect: what does it mean in behavioural finance?

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 assets that are gaining value (the winners) too soon. The standard method of disposition is selling stocks in the stock market. 

Individual Investors are willing to realise or cash in their gains but are more reluctant to acknowledge their losses. To the average person, this attitude makes sense; you have made a decision and taken a risk with your money, and you want to see that risk pay off. 

But from a financial 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.

Hersh Shefrin and Meir Statman first introduced this effect in a Journal of Finance paper called “The Disposition to Sell Winners Too Early and Ride Losers Too Long: Theory and Evidence”. The journal explains in detail the behaviour pattern of investors when it comes to making investment choices caused to the uncertainty of the stock market.

The journal focuses on the decisions to realise a gain and loss, particularly the reluctance of investors to sell and realise a loss. 

Disposition effect examples

There are some examples of the disposition effect.

Example 1. Suppose an investor bought a Tesla stock for £750 in their general investment account two months ago, and it is now selling for £500. The investor must decide whether to realize a loss or keep the stock. The investor has two options.

    1. Sell the Tesla stock and realize a loss of £250
    2. Keep the Tesla stock as there is a 50/50 chance of losing more money (£250) or breaking even. 

Based on the disposition effect: The investor is more likely to keep the Tesla stock rather than take the loss. There is more risk-taking behaviour when faced with a loss.

Example 2. If an investor both a cryptocurrency £10,000 five years ago and the price has risen to £40,000. The investor must decide whether to realize a gain or keep the stock in their portfolio. The investor has two options.

    1. Sell the cryptocurrency stock and realize a gain of £30,000
    2. Keep the cryptocurrency stock as there is a 50/50 chance of making more money (£30,000). 

Based on the disposition effect: The investor is more likely to sell the cryptocurrency rather than keep it. There is the selling winners’ behaviour when faced with profit.

Example 3. A day trader made 35% losses on their trades in the morning. The trader has two options.

    1. Stop trading for the day and resume the next day.
    2. Continue trading, even though there is a 50/50 chance of breaking even or losing more money on trades taken in the afternoon. 

Based on the disposition effect: The day trader is more likely to keep on trading rather than take the loss for the day.

Focus on your final wealth level

According to the 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 the investment risk, they may be liable to hold on to losing stock that has decreased in value in the hope that it might gain.

The disposition effect is based on the prospect theory or the “loss-aversion theory” concept, which states that investors value gains more highly than losses. Both theories are part of behavioural economics. An example of the prospect theory is an individual choosing to receive £150 outright instead of receiving £300 and then giving back £150, even though the end result is still a gain of £150. 

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.

Studies have shown that the disposition effect is more evident in individuals with a lower understanding of investing, which is unsurprising. It is not easy for an individual to go against their psychology.

Learning how to invest money in the short or long term and following an investment strategy is the goal. Do not hold onto a stock due to the ‘fear of missing out’ or sell a stock prematurely to lock in some profit if it is not in line with your investment strategy or your financial objective. Always focus on your financial wealth level.

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 investment 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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