By losers in this article, we’re not referring to humans. Even though, there might possibly be a correlation between the disposition effect and holding on to bad partners for too long.
In this article, the focus is on one effect that causes traders to sell winning assets too fast and realize losses too late. Have you ever felt regret after selling a winning stock and saw it continuing to rally? Or held on to a losing asset for too long, trying to tell yourself that it’ll go up again but it never did?
If the answer is yes, you’re not alone. You’ve experienced the disposition effect.
The term disposition effect was introduced by Shefrin and Stateman in 1985 who researched the behaviour of investors when it came to realizing losses and gains. In doing so they encountered a discrepancy:
Investors were more likely to sell winners too soon and hold on to losers too long.
They called this effect disposition effect (Shefrin & Stateman 1985).
A few years later the effect was furtherly investigated by Odean who came up with a formula to calculate the effect. He differentiated between
- Realized Gains: assets that had gained since purchase and were sold
- Realized Losses: assets that had lost since purchase and were sold
- Paper Gains: assets that had gained, but were still being held
- Paper Losses: assets that had lost, but were still being held
Equipped with this differentiation of losses and gains he created the below formula to calculate if investors are proportionally selling more winning stocks or more losing stocks.
When the Proportion of Gains realized is bigger than the Proportion of Losses realized, we’ve investors that prefer selling winners. Applied to 10,000 trading accounts in his research group, Odean found that the proportion of realized gains was 14.8% while losses were only realized at 9.8%. Interestingly enough, this effect seemed to diminish in December, but later more on that.
Most studies that followed, were supported the thesis that we prefer to sell winners and keep losers for too long. As a little comfort, it looks as if investors that trade more frequently and have more experience are less prone to the effect.
Now we know, we’re not alone. But the big question is still, why are we doing this?
Trying to find the WHY
Since the first documentation of the disposition effect, researchers and economists have tried to find explanations for it.
Traditional economics model of the human as a rational being that makes decisions that benefit themselves most, the so-called homo economicus, would definitely not engage in such behaviour.
Nevertheless, possible rational explanations included
- trading costs: the more investment is gaining in value, the lower the trading costs will be in proportion.
- Portfolio rebalancing: rebalancing your portfolio to not have too much exposure in one industry/company etc.
- Private information: insights into a company, insider knowledge that makes investors confident that their stocks will go up. Such a trading pattern would resemble the disposition effect.
For all these 3 ideas, no supporting evidence has been found. So, another explanation was needed. An explanation focusing on our not so rational side.
4 different concepts feed into the reasoning behind the disposition effect.
Imagine you were asked if you’d rather receive $100 for certain or gamble for a 50:50 chance to win $0 or $200. Most people will go for the $100 and not take the bet.
What about a situation in which you’ll either have to pay $100 for sure or have the chance to gamble for a 50:50 chance to pay $0 or $100. What will you do, take the gamble?
Kahneman and Tversky (1979) found that we’re risk-averse in risky situations that lead to gains while we’re more risk-seeking in situations that lead to losses as long as they have the potential to avoid a loss.
Applied to our tendencies investing, we prefer to take the sure gain and take the gamble on our losing investments.
Even if you’re not aware of it, we all have a tendency to do mental accounting with our finances. In our mental accounts, we treat money received from salary different than money saved on a purchase. Usually, mental accounting doesn’t cause us any harm.
But sometimes, we can lose the bigger picture of our financial well-being because we focus too much on one account.
When we buy a stock or any other asset, we evaluate its performance in relation to the price we bought it at. Each asset in our portfolio will be considered separately and not as part of your overall portfolio. Maybe you bought in at a bad time, so you make loss on one stock. But you want to at least break-even, which is why you keep it. Even though had you had a look at the bigger picture, you might realize that selling would benefit you more.
Do you like to feel regret? Do you like having to admit that you’ve made a mistake? Of course not. No one does. It’s nothing we derive pleasure from.
Investors fear the emotion of pain and regret that will come with selling a losing stock that they hold on to it. As long as they don’t sell, their loss is not realized and they don’t have to admit their mistake.
A little hint, if you’re serious about trading and investing, this is something you want to overcome. Every trader makes losses from time to time. They are part of the trading journey.
Last, but not least, self-control plays a role in us selling before we hit the peak and keeping our losing assets.
You might have made a trading plan with the best intentions to stick to it, but then you see one of your favourite assets tumbling and just can’t get yourself to execute that stop-loss.
What also speaks for the impact of self-control is the finding that in December the disposition effect is diminishing. This is attributed to the end of the tax year, which acts as an explicit self-control mechanism. We sell more losing stocks at the end of the year to pay less tax. Easy as that.
Turns out again, that we’re not the rational beings we’d like to think. What’s important is to be aware of the bias and effects that influence your investment and trading decisions. The more you know, the more informed decisions you can make. Before selling a winner, look at the charts, news and any other source of information you rely on to figure out if it might not be too early to sell. Re-assess the losing assets in your portfolio on a regular basis and ask yourself, am I just trying to avoid the feeling of regret?
Trading and Investing aren’t easy and little defeats on the way are just part of the whole experience.
In that sense, Happy Investing.