Glossary

Disposition effect

Investors have a tendency to hold onto losing positions long after we know in our heart of hearts, the stock is never going to recover, and to take profits on winning positions too early.

Investors don't like to lose money. That's understandable. However, it gives rise to a very damaging tendency to hold onto losing positions long after we know in our heart of hearts, the stock is never going to recover (and that even if it does, it'll never compensate for the opportunity costs we've incurred in the meantime). A frequent corollary is that we also tend to take profits on winning positions too early we want to lock in the gains we've made for fear of losing them.

This particular behavioural quirk is known as the "disposition effect". It was named by Hersh Shefrin and Meir Statman in a 1985 paper, and has been widely observed in many contexts. At the heart of the issue is the fact that human beings do not regard wins and losses equally. Instead, according to "prospect theory" (identified in a 1979 study by behavioural finance pioneers Daniel Kahneman and Amos Tversky) we feel the pain of a loss twice as powerfully as the joy of a gain. In other words, winning £100 has the same positive emotional impact as losing £50 has negative impact.

Subscribe to MoneyWeek

Become a smarter, better informed investor with MoneyWeek.

This also means we can end up taking irrational risks to avoid losing money (for example, gambling more money to try to recover earlier losses), even though when we are in a winning position, we tend to avoid taking even moderate risks that might boost our gains.

Simply being aware of it is of little help in avoiding the disposition effect. Instead you have to plan in advance how to react in a situation where it might kick in. Setting a stop loss a value below your purchase price at which you commit to sell when you invest is one way to cut losses short, although make sure you leave enough room for manoeuvre (don't set a stop at just 5% below your purchase price for example). Meanwhile, gradually moving a stop loss up as your investment moves into profit, can give you the confidence to hang on for longer.

Advertisement

Most Popular

Visit/economy/600632/money-minute-friday-17-january-uk-weakness-likely-to-continue
Economy

Money Minute Friday 17 January: UK weakness likely to continue

Today's Money Minute previews UK retail sales figures the UK, inflation data from Europe and industrial production from the US.
17 Jan 2020
Visit/investments/property/house-prices/600638/uk-house-prices-may-be-heading-for-a-boris-bounce
House prices

UK house prices may be heading for a Boris bounce

The latest survey of estate agents and surveyors from the Royal Institution of Chartered Surveyors is "unambiguously positive" – suggesting house pric…
16 Jan 2020
Visit/520525/currency-corner-how-high-can-the-pound-go-against-the-euro-in-2020
Currencies

Currency Corner: how high can the pound go against the euro in 2020?

In the month in which we should finally leave the European Union, Dominic Frisby takes a look at the pound vs the euro and asks just how high sterling…
13 Jan 2020
Visit/investments/stocks-and-shares/share-tips/600636/class-acts-going-cheap-buy-into-europes-best
Share tips

Class acts going cheap: buy into Europe’s best bargains

Value investing appears to be making a comeback, while shares on this side of the Atlantic are more appealing on metrics such as price/earnings ratios…
16 Jan 2020