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.

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.

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