What Is Disposition Effect?
The disposition effect is a pervasive cognitive bias in behavioral finance that describes the tendency of investors to sell assets that have appreciated in value ("winners") too early, while holding onto assets that have decreased in value ("losers") for too long. This behavior is driven by emotional discomfort associated with realizing a loss and the psychological pleasure of locking in a gain, often leading to suboptimal portfolio performance.67, 68, 69 The disposition effect can reduce overall returns and increase exposure to risk by tying up capital in underperforming assets.65, 66
History and Origin
The disposition effect was first identified and named by Hersh Shefrin and Meir Statman in their seminal 1985 paper, "The Disposition to Sell Winners Too Early and Ride Losers Too Long: Theory and Evidence".62, 63, 64 Their research built upon the foundational work of Daniel Kahneman and Amos Tversky, who developed prospect theory in 1979.60, 61 Prospect theory posits that individuals value losses and gains disproportionately, typically feeling the pain of a loss more intensely than the pleasure of an equivalent gain, a concept known as loss aversion.58, 59 Shefrin and Statman aimed to investigate these loss aversion behaviors within a market setting, moving beyond controlled experimental data to analyze real-world trading patterns.57 They observed that investors were more inclined to secure profits from rising stocks but were reluctant to sell declining stocks, hoping for a recovery.55, 56 This "get-even-itis" predisposition was found to contradict rational economic models.
Key Takeaways
- The disposition effect is a behavioral bias causing investors to prematurely sell winning investments and excessively hold onto losing ones.52, 53, 54
- It is largely explained by loss aversion and mental accounting, alongside the desire to avoid regret and seek pride.50, 51
- This bias can lead to decreased investment returns and increased tax liabilities due to suboptimal capital gains and capital losses realization.49
- While prevalent among individual investors, the disposition effect can also affect institutional investors and mutual fund managers.46, 47, 48
- Strategies to mitigate the disposition effect include setting predefined trading rules, regularly reviewing portfolios, focusing on fundamentals, and maintaining proper diversification.45
Formula and Calculation
While there isn't a single "formula" for the disposition effect itself, its presence is typically measured by comparing the propensity to realize gains (PGR) versus the propensity to realize losses (PLR). A widely used methodology, developed by Terrance Odean in 1998, involves tracking an investor's realized gains and losses against their unrealized gains and losses over a period.44
The propensity to realize gains (PGR) is calculated as:
The propensity to realize losses (PLR) is calculated as:
In this context:
- Realized Gains are profits from sold assets.
- Paper Gains (or Unrealized Gains) are profits from assets still held.
- Realized Losses are losses from sold assets.
- Paper Losses (or Unrealized Losses) are losses from assets still held.
The disposition effect is demonstrated when PGR is significantly higher than PLR. For instance, Odean (1998) found that investors were 50% more likely to realize gains than losses, with an average PGR of 14.8% and PLR of 9.8%.43 Comparing these ratios helps to eliminate the influence of market conditions, as it assesses behavior relative to available opportunities.42
Interpreting the Disposition Effect
Interpreting the disposition effect involves understanding its impact on investor decision-making. Investors exhibiting this bias tend to display risk aversion when it comes to gains, eager to lock in profits, even if doing so means missing out on further appreciation. Conversely, they exhibit risk-seeking behavior when facing losses, holding onto declining assets in the hope of a rebound to their original reference point or break-even price.40, 41
This pattern of behavior often leads to reduced returns because assets that have recently performed well tend to continue performing well, while those that have performed poorly tend to continue underperforming.38, 39 Therefore, acting against the disposition effect—by letting winners run and cutting losers—is often considered more financially advantageous.
##37 Hypothetical Example
Consider an investor, Sarah, who purchased 100 shares of Company X at $50 per share and 100 shares of Company Y at $50 per share.
After six months:
- Company X's stock price rises to $75 per share. Sarah now has a paper gain of $2,500.
- Company Y's stock price falls to $25 per share. Sarah now has a paper loss of $2,500.
Driven by the disposition effect, Sarah might decide to sell her 100 shares of Company X to "lock in" the $2,500 profit. Simultaneously, she might hold onto her 100 shares of Company Y, hoping that the price will recover to her original purchase price of $50, thereby avoiding the pain of realizing a $2,500 loss. This behavior, while emotionally satisfying in the short term, could lead to missing further gains from Company X and incurring larger losses from Company Y if its price continues to decline.
Practical Applications
The disposition effect manifests widely in financial markets, influencing the trading strategies of various investor types. It is observed in private investors, institutional traders, and fund managers alike, though its intensity can vary. For34, 35, 36 instance, studies have shown that mutual funds exhibiting strong disposition tendencies can underperform their peers.
Th33is bias can lead to several negative outcomes:
- Suboptimal Tax Decisions: Investors may realize short-term capital gains, which are often taxed at higher rates, while deferring capital losses that could offset those gains.
- 31, 32 Reduced Diversification: Holding onto losing stocks can tie up capital in underperforming assets, preventing reallocation to more promising opportunities and potentially leading to an imbalanced portfolio.
- 30 Market Inefficiencies: Widespread reluctance to sell losing stocks can delay price corrections and reinforce momentum trading patterns, impacting market efficiency.
Re28, 29al-world market events, such as the 2017 Bitcoin market boom and bust, have shown that the disposition effect can become more pronounced during volatile periods, affecting cryptocurrency investors. Fur27thermore, the collective behavior of individual investors, often influenced by biases like the disposition effect, can contribute to significant shifts in wealth markets, as observed in the UK following the COVID-19 pandemic.
##26 Limitations and Criticisms
While widely documented, the disposition effect faces some criticisms and has recognized limitations. One primary area of debate revolves around its underlying mechanisms. While prospect theory and loss aversion are often cited as key drivers, some researchers argue that these theories alone may not fully explain the phenomenon, suggesting that emotions like regret and elation also play a crucial role.
An24, 25other critique questions the rationality of the disposition effect in certain market conditions. For example, some models suggest that a belief in mean reversion—the idea that asset prices will eventually return to their long-term average—could lead to holding onto losers, which could be rational if the belief holds true. However, empirical evidence often casts doubt on this, especially in non-mean reverting markets.
Furthe22, 23rmore, interventions aimed at mitigating the disposition effect, such as reducing the saliency of purchase price information, have shown some success in laboratory settings. However, studies also indicate that even with such interventions, investors may still exhibit suboptimal trading behavior, suggesting that the bias is deeply ingrained. The dis20, 21position effect can also be influenced by demographic variables such as age, gender, experience, and investor sophistication, with less experienced investors often more prone to the bias.
Dis18, 19position Effect vs. Loss Aversion
While closely related, the disposition effect and loss aversion are distinct concepts in behavioral finance.
| Feature | Disposition Effect | Loss Aversion |
|---|---|---|
| Definition | The tendency to sell winning investments too early and hold losing investments too long. | The psychological phenomenon where the pain of losing something is felt more intensely than the pleasure of gaining an equivalent amount. |
| Scope | Primarily observed in financial decision-making, specifically trading and investment. | A broader cognitive bias that affects decision-making across various domains, not just finance. |
| Behavioral Outcome | Leads to holding onto underperforming assets and prematurely selling outperforming assets. | Influences decisions by making individuals more likely to avoid a potential loss than risk a potential gain. |
| Relationship | The disposition effect is largely considered a manifestation or consequence of loss aversion in the context of investment decisions. | Loss aversion is a foundational psychological principle that helps explain why the disposition effect occurs. |
In essence, investors exhibit the disposition effect because they are affected by loss aversion. The strong aversion to realizing a loss drives the reluctance to sell losing investments, while the desire to experience the pleasure of a gain prompts the quick sale of winners.
FAQ15, 16, 17s
What causes the disposition effect?
The disposition effect is primarily caused by psychological factors such as loss aversion and the desire to avoid regret. Investors feel more pain from realizing a loss than pleasure from an equivalent gain, leading them to hold onto losers hoping for recovery. They also sell winners quickly to experience the pride of a realized gain and avoid the regret of watching a paper gain turn into a loss.
Ho12, 13, 14w can investors avoid the disposition effect?
Investors can mitigate the disposition effect by implementing disciplined trading strategies and focusing on rational decision-making. This includes setting clear, predetermined criteria for buying and selling assets, regularly reviewing one's portfolio without emotional attachment, and concentrating on the fundamental value of investments rather than short-term price fluctuations. Utilizing strategies like dollar-cost averaging and maintaining proper diversification can also help.
Do10, 11es the disposition effect only apply to individual investors?
No, while the disposition effect is widely documented among individual investors, studies have also shown its presence in institutional investors and professional fund managers. However7, 8, 9, the intensity and manifestation of the bias can vary across different types of investors and market conditions.
Is5, 6 the disposition effect always detrimental?
Generally, the disposition effect is considered detrimental to investment returns. By holding onto losing stocks, investors miss opportunities to reallocate capital to more promising investments, and by selling winners too early, they may forgo potential future gains. Researc2, 3, 4h indicates that losing stocks held by investors affected by the disposition effect tend to underperform compared to the winning stocks they sell.1