The disposition effect
All investors are prone to behaviours and emotions that can lead to poor investment decisions. One of the most common of these is the tendency to sell investments that have risen in value, and hold on to investments that have fallen in value. In 1985 two academics, Shefrin and Statmen, studied this behaviour and coined it the ‘disposition effect’.
The disposition effect quickly destroys value in two ways:
- An investor misses out on the returns of a rising asset.
- They continue to hold investments that are falling in value.
Of course if an investor sells all the winners and keeps the losers, they eventually end up with a portfolio of losers!
It’s nearly impossible to avoid losses altogether, but it is possible to minimise them. Cutting losses may seem an obvious thing to do, but it’s less common than you might think.
The disposition effect – a case study
It’s January 2012 and David starts the new year by investing $10,000 in casino operator ABC Casino and $10,000 in mining company XYZ Mining.
Six months on, and ABC Casino has performed well, rising by 31%. David is very happy with this return and can’t see the stock rising much further. He sells the stock, earning a $3,100 profit. He is very pleased with his stock-picking ability.
Meanwhile, David’s holding in XYZ Mining has fallen in value by 25% over the six months. He can’t believe his bad luck, but comforts himself that this is only a ‘paper loss’ – because he hasn’t sold the stock yet, he hasn’t realised the loss. David hangs on to the stock because he can’t afford to realise the loss and thinks that one day it will return to what he paid for it.
Fast forward to the end of the 2013, and David still holds XYZ Mining. Because the stock was performing badly, he lost interest and neglected his investment.
Unfortunately, the XYZ Mining share price continued to fall and David’s investment is now worth just $5,035. Even taking into account the profit he made from the sale of ABC Casino, David is faced with a net loss of $1,865. To make matters worse, ABC Casino rose a further 262% after David sold his shares. David is kicking himself for missing out on this return.
In a different scenario, if David had instead sold his XYZ Mining shares and kept his ABC Casino shares, they would now be worth $48,841. Even taking into account the loss he would have realised when selling XYZ Mining, this is a net profit of more than $31,000 on his original $10,000 investment.
This is an illustrative example of what can happen if you sell a winning stock too early and hold on to a losing stock too long. Of course the same principle applies to all investments, whether individual shares or a portfolio of investments.
Exhibit 1: ABC Casino vs XYZ Mining: cut your losses and let your winners run
What went wrong
David fell into a few common traps when managing his investment:
Trying to pick the top
Many investors sell their shares when they think they have reached the maximum price and the only way is down. In this example, David thought that the ABC Casino share price couldn’t rise much more after it rose 31% in six months – a stellar return. However, the future value of a stock is completely unrelated to its purchase price.
Congratulating yourself on your stock-picking ability when stocks go up, and blaming ‘bad luck’ when stocks go down is called ‘self-attribution bias’. Many of us are guilty of it. Self-attribution bias leads to over-confidence in investment abilities and deters investors from seeking professional advice.
When an investment goes bad, many investors comfort themselves and avoid admitting a mistake by viewing it as only a ‘paper loss’. However a loss on paper is just as important as a realised loss. Investors are often willing to realise gains but unwilling to realise losses. This is the underlying cause of the disposition effect.
When stock markets are rising, many investors enjoy watching the value of their investment grow and take a keen interest. When investments go down, the opposite is true. It’s important to always monitor and manage your investments whatever the market conditions.
Opportunity cost is the price paid for following one choice at the expense of another. In this case study, David has passed up the opportunity of holding a stock rising in value by continuing to hold XYZ Mining.
After an investment falls in value, many investors plan to hold onto it until it returns to its purchase price, meaning they will break even and erase their mistake. Unfortunately, this may never happen. In the case study above, XYZ Mining will have to rise 100% to return to what David paid for it two years earlier. Many stocks never regain their previous highs.
Avoiding the pitfalls
Many investors sabotage their own investment success without even realising. One of the key ways to avoid this is to recognise and understand behaviours and emotions that can lead to poor investment decisions.
Long-term investing in a professionally-managed fund is a good way to avoid the common pitfalls. Experienced fund managers typically apply more discipline to their investment process and so are less inclined to make emotional decisions than investors who hold shares directly.