Disposition Effect

The disposition effect is the tendency to sell investments that have gone up too quickly and hold investments that have gone down for too long. Economists Hersh Shefrin and Meir Statman named it in 1985. It is one of the most consistent findings in studies of how individuals actually trade, and it runs directly against the old trading advice to "cut your losses and let your profits run".

The evidence#

In a widely cited 1998 study of about 10,000 brokerage accounts, Terrance Odean found that investors were significantly more likely to sell a stock that was up than one that was down. Even more telling, the winners they sold tended to keep outperforming over the following year, while the losers they held tended to keep underperforming. The investors were systematically selling the wrong stocks.

Why it happens#

What it does to results#

The pattern produces a high win rate with low average wins and large average losses, a combination that looks good in conversation and bad on statements. See Expectancy and Win Rate and Payoff Ratio.

Reversing the disposition effect#

1. Decide exits before entry. Place a stop and a profit plan with the entry, ideally as a bracket order. See Bracket Orders.
2. Let the plan, not the purchase price, decide. Ask "would I buy this position today at this price?" If not, why hold it?
3. Use trailing stops for winners so you exit on a meaningful reversal rather than the first profit. See Trailing Stop Orders.
4. Never move stops further away. See Stop Loss Strategies.
5. Track average win and average loss in your journal. If average losses exceed planned risk, or average wins are much smaller than planned targets, the disposition effect may be at work. See Trading Journal.
6. Review MAE and MFE to see whether you exit winners well before their potential. See MAE and MFE.

Taxes and the disposition effect#

In many countries, realising losses can reduce taxes, which gives a financial reason to sell losers rather than hold them. Yet many investors still hold losers, showing how strong the emotional pull is. See Tax-Loss Harvesting.

Common mistakes#

• Treating the purchase price as meaningful to future price movement.
• Calling a losing trade a long term investment to avoid selling it.
• Taking quick profits to feel successful.

Frequently asked questions#

What is the disposition effect?#

The tendency to sell winning investments too soon and hold losing investments too long.

Why is the disposition effect harmful?#

It shrinks average wins and enlarges average losses, which can make a strategy unprofitable even with a high win rate.

How do I avoid the disposition effect?#

Set stops and profit plans before entering, use trailing stops for winners, never move stops further away and track your average win versus loss.

Next, learn how recent events distort judgement in Recency Bias.

Sources#

• Wikipedia, Disposition effect