The disposition effect is related to the way investors tend to treat unrealised gains and losses on financial assets. In particular, research found that investors have the tendency to realize gains more quickly than losses. Investors tend to “hold on to losers, but sell winners”. From an investment perspective, this behavior does not make sense. A security’s future performance is unrelated to the price at which the investor purchased the security.
The term ‘disposition effect’ is a shorthand for investors’ ‘predisposition towards get-evenitis‘. As such, the term refers to a likely explanation as to why people tend to behave like this; investors are hoping to get even. This is because selling a position at a loss would be the same as admitting that they were wrong on a trade. At the same time, realising gains ‘proves’ that the investor was right. In other words, investors avoid regret and instead seek pride.
The disposition effect is closely related to prospect theory and loss aversion.
In this particular case, investors are using the purchase price of a security as the reference point. The security’s performance is interpreted relative to this reference point. That explains why the purchase price is so important in investors’ decision making. From the discussion of the value function, we know that prospect theory predicts that people are loss averse. This means that they dislike realising losses more than they like realising gains.
One reason investors should be aware of the disposition effect, is the following. Some studies found that the stocks investors sell due to the disposition effect (the winners) tend to outperform the stocks investors continue to hold (the losers). This means that investors would therefore be better off by holding the well performing stocks longer and getting rid of the losing stocks sooner. By holding on to winning stocks, which tend to continue to win, investors can benefit from stock momentum.
The disposition effect is not just relevant from an academic perspective. Suffering from this behavioral bias can be detrimental to investors’ performance. To avoid disposition effect from being a drag on performance, investors should periodically consider selling underperforming assets.