“Run your winners and cut your losses” is one of Wall Street’s most enduring pieces of advice, championed by investment legends like Peter Lynch and Warren Buffett and consistent with academic studies of market momentum. Yet, despite the simplicity of this mantra and its undeniable economic rationality, research indicates that people often do the opposite. This tendency to sell winning investments too soon and retain losing holdings is so well-known that it has its own term – the disposition effect.
The disposition effect is a significant behavioural bias that can have substantial implications for investment outcomes. As a former professional investor now turned academic and private investor, I am aware that many of my investment decisions suffer from it. However, I know I am not alone, as I observe this phenomenon among friends and peers, both past and present.
So why do so many of us exhibit the disposition effect? Despite four decades of research, we do not fully understand the underlying mechanism for this irrational behaviour. What we do know is that the phenomenon is widespread; it is evidenced in developed markets like the US and Germany, as well as in emerging markets such as China, Indonesia, and Saudi Arabia.
While the effect is witnessed among men and women across different demographics, the level and intensity can vary. Although it appears more prevalent in retail investors, it is also evidenced among professional investors. And it’s not just equity investors that are impacted; it is seen among forex traders, housing market purchases, and even in spread betters in the NFL (National Football League) and NBA (National Basketball Association). The disposition effect is known to be irrational and leads to underperformance with smaller profits, larger losses, lower post-tax returns, and a lower quality portfolio.
Several theories have been offered as explanations for the phenomenon. Many focus on the idea that we are influenced by emotions like regret and pride. It is suggested that we tend to sell things that have gone up in value quickly because we do not want to regret missing out on the profit if the value goes back down. On the other hand, loss aversion suggests that the pain of realising a loss is more intense than the pleasure of realising a gain, leading investors to avoid selling losing stocks, hoping they will recover, rather than facing the immediate pain of a loss. This could also explain why gamblers also keep betting even if they are overall losers; they recall their wins (even if far fewer/smaller) much more than their losses – the Dopamine hit is addictive.
This sort of irrational thinking is not what our wealth-maximising economic theory suggests. Perhaps we should not be surprised; after all, we have evolved over millions of years and at our very core, we are complex emotional beings that may not always make decisions with cold, hard, rational, robot-like logic.
In conclusion, the disposition effect is a pervasive, irrational behavioural bias affecting investors, leading to suboptimal investment outcomes. Understanding why the disposition effect is so prevalent remains a mystery, and research is ongoing. In fact, research into the underlying mechanism is the focus of my doctoral thesis. Perhaps in 4-5 years, I’ll be in a better position to provide more insights and hopefully offer strategies to mitigate the disposition effect.
Vijay Tohani, ShareSoc director and Senior lecturer
This article reflects the opinions of its author and not necessarily those of ShareSoc.
Investing in stocks and shares is not within a perfect market. You don’t have perfect information, for one thing insider dealing is illegal….
The way this article is phrased is still misleading in that it implies that good or bad past performance is likely to persist in the future, and if anything there’s less evidence for that than the contrary. The truth is that the past is past and should have no influence on your view of the future.
@Stephen there is a huge body of evidence supporting the momentum effect. It’s a major plank of Factor investing. See https://en.wikipedia.org/wiki/Momentum_(finance). I agree it’s not completely intuitive, and it’s usually in contention with a mean reversion tendency, but it definitely exists and is well researched.