What is the Disposition Effect?
Have you heard the phrase, “don’t cut the flowers and water the weeds”? If so, that is the essence of the disposition effect–that investors will sell winning stocks and hang on to losing stocks. Knowing this is half the battle, so keep reading to learn how I first came to learn about this bias, how I took significant risk to learn experientially, why it affects us in so many ways, and how to learn how you can overcome this destructive bias.
Putting My Money Where My Mouth Is
When I was a PhD student at Claremont, I was hired to teach behavioral finance at the undergraduate colleges.
After getting the offer I feared that these smart Pomona, Claremont McKenna, Harvey Mudd, Scripps, and Pitzer students would be bored by textbook examples and purely academic discussions and would enjoy hearing about their own professor putting money at play and have something experiential to talk about.
So in addition to preparing for lectures by boning up on theory and the vast literature, I also decided to get “real world” experience by taking out all available student loans and investing and managing the money myself in a brokerage account as a self-directed investor.
After a few months of trading I read both and had significant cognitive dissonance with the findings in relation to my own trading decisions. I resisted accepting the results because I wanted to justify why I didn’t sell my losing stocks. “It’s going to come back! Don’t sell now!” I thought to myself.
But it was no use, the same results showed up in subsequent research and years later I replicated the findings in my own work in a large bank’s retail trader database.
Among the many book chapters and research papers I read in preparing my lectures, one behavioral bias stood out to me. It was called, unhelpfully, the disposition effect. The first paper published on the topic came out in 1985 by the legendary behavioral finance duo from Santa Clara, Meir Statman and Hersh Shefrin.
In this groundbreaking paper they explain why people make decisions that deviate from what a perfectly “rational” investor would do from a behavioral perspective and offer various reasons why people display this wealth-destroying pattern.
Another paper on the same topic was published by Terry Odean from UC Berkeley (here’s a copy of it) that analyzed trades from individuals to cleanly empirically test the impact of this bias. The results showed that many of these self-directed investors were selling winning stocks early, and that losing stocks were not being sold, causing significant losses for the portfolios. In addition to this startling result, further analysis showed that the winning stocks that were sold went on to outperform over short and long periods.
Can’t unsee it
At first it doesn’t sound like a big deal, but when you read the research on this, it hits home quickly.
Of course each investment scenario is unique and there are exceptions to the rule that losers should not be sold, but from an aggregate, quantitative perspective the results showed that investors tend to sell paper gains and not sell paper losses.
There are scenarios where an asset is mispriced and not selling is the right move, but knowing when, how much, and for how long are all complicated questions.
Since Statman and Shefrin’s groundbreaking paper, there have been many, many papers published on the topic across subfields, including decision neuroscience. Results show that the disposition effect appears not just with common stock trading, but in bonds, FOREX, crypto, real estate and corporate M&A (see Fig. ? below) and among both everyday people and professionals.
We see that the pattern of avoiding selling losing positions and quickly selling winners pervades across these areas suggesting that this is a generalizable behavior across asset classes.
Most behaviors emerge from the same general cognitive or neural process and so can be found across many domains. For example, risk aversion can be found across all aspects of human life, it just so happens that financial decisions lend themselves to easy measurement so we talk about it more often in economics. Likewise, the Disposition Effect emerges and re-emerges across asset classes (see Table 1) and even professionals with years of experience display it.
What struck me was how clear the results were and how they held up to what’s called “robustness testing”, which is where various statistical methods are used to make sure that the same result can be found across time scales and samples so that we can have a stronger conviction in the results being statistically real.
Applying research findings directly to one’s own life is a bad idea.
But why is it a bad idea?
There are two reasons:
The first is that research relies on statistical strength of large samples to provide meaningful results. However, any individual within that sample may or may not have the trait itself. This is why individualized analytics are critical and one-size-fits-all policy often backfires.
Also, directly applying findings from research to your own life without considering your baseline state is like what many medical students do when they learn about diseases. This phenomenon is called medical student syndrome (or medical student disease) and captures the tendency of medical students (and sometimes other health professionals in training) to perceive themselves as having the symptoms of the diseases they are studying.
This is thought to result partly from heightened self-awareness and likely associated exaggeration of any similarity to the symptoms in their textbooks.
However, when it comes to investing, we can’t just look at our data, trades, or performance and be able to diagnose ourselves. And this very absence of helpful analytics led me to wonder why my investment platform doesn’t offer disposition effect insights.
Not to worry, I went ahead and built Prof of Wall Street to do just that: read your trades and show you whether you have the disposition effect (and other pernicious biases) immediately.
Here’s how we help you see if you have the disposition effect….
Overcoming the Disposition Effect
In the original paper by Shefrin and Statman they discuss prospect theory, mental accounting, seeking price and avoiding regret, and self control. Although interesting, the findings are not prescriptive or particularly applicable in the heat of the moment. Since then there are a few research projects where the goal was to test whether the Disposition Effect could be fixed, or at least reduced.
Practical, General Approach
Identify
The simple move is to experience the discomfort and fear of having a stock gain in value and sell only if there are objective reasons to do so (impulsive desire to profit does not count as a good reason).
Amending this tendency requires recognizing the habit, understanding the impact it has, and to learn new behaviors such as selling losing stocks and allowing winning stocks to rise at least to their intrinsic value (despite the emotional discomfort of doing so).
Motivate
Tax Implications: Rarely do taxes motivate people to act in their best interest, but here are two useful motivators:
The first involves taking advantage of lower long-term tax rates. As investor sophistication increases among those who read investor-focused journalism, more everyday investors are seizing the opportunities to sell their losing stocks due to tax loss harvesting motivations (example). But waiting until year-end to sell a losing position is probably insufficient to create a reliable and timely decision process to reduce the disposition effect.
Along the same theme, there are also tax negative implications of realizing gains quickly and frequently due to differences between short- and long-term capital gain tax categories created by the IRS. Short-term gains are more punitive and reduce investment returns in yet another invisible way, as most investors look at their performance instead of the downstream consequences of their decisions. As of this writing, short-term capital gains are and long-term are , a meaningful difference.
Short-term gains tax rate: Taxed at your ordinary income tax rate, which depends on your income level and tax bracket. This could range from 10% to 37% (in the U.S., as of 2023). If you buy $100 worth of stock and sell it within a year for $150, your gain is $50. If you’re in the 22% tax bracket, the tax on your gain would be $50 × 22% = $11.
In contrast, long-term capital gains (from the sale of stocks held for more than one year), the tax Rate: Taxed at preferential rates based on your taxable income (0% for low-income earners; 15% for middle-income earners; 20% for high-income earners). For example, if you buy $100 worth of stock and sell it after more than a year for $150, your gain is $50. If you’re in the 15% capital gains tax bracket, the tax on your gain would be $50 × 15% = $7.50. The difference between these gains is almost 32%.
Some additional factors to consider are that some states in the U.S. impose additional taxes on capital gains. Also, this example assumes these are not tax-sheltered accounts (e.g., IRA, 401(k)).
Execute: Just Do It
One approach we recommend for all investors is to evaluate every losing position and ask if that money can be put towards a better thesis. Almost every investor has losing positions in their portfolio, so why not periodically do a “disposition effect cleanup”?
Yes, this would mean incurring the remarkably light pain of selling, but what comes next is surprising: a strong feeling of elation, empowerment, and a sense of control over your own portfolio and financial future…. To clarify: this is not to be taken as a literal directive or decision rule to sell all losing stocks. It is meant to pose two questions:
a.) what is/are my motivation(s) for holding this position, and
b.) what is the likely future trajectory of this asset in my relevant time period? If the motivation is driven by avoiding selling a loser due to loss aversion, this is not a good reason to not act. If the future trajectory is not good, then take the opportunity to recognize the difference between an emotional rationale and a purely economic rationale.
Behavioral Financial Technology
Many behavioral interventions fail by having no effect and some even backfire by increasing the very behavior they were implemented to reduce. Beyond no effect and opposite effect outcomes, sometimes offsetting side effects can occur such as the rebound effect observed when people switch to low-energy light bulbs they leave them on longer.
Here is how behavioral financial technology tackles the disposition effect for each individual investor and carefully avoids these known problems:
Diagnosing the Disposition Effect
The only way to diagnose your investment account (or your financial advisor) is to analyze trade data on the Prof of Wall Street platform. We are proud to be the first financial technology company in the world to be able to pull data directly from an investor account, analyze the trades, and provide a rapid graphical estimation of the impact of the disposition effect on portfolio performance.
The behavioral modules were built explicitly and exclusively to provide investors a rapid diagnosis of active portfolio management so they can know quickly if they are destroying value due to the disposition effect.
Once your data are pulled, you get a graph showing your portfolio performance and the same portfolio with a reduction in the disposition effect. The graph is simple: it shows the account performance in blue, then a “counterfactual” portfolio in red. The counterfactual portfolio is obtained by ‘dialing down’ the disposition effect to show what the portfolio performance would have been. Specifically, this entails selling winning stocks later and selling losing stocks sooner.
Sometimes the results are dramatic and warrant attention and work on the part of the investor. Sometimes there is little difference between the actual portfolio and the backtested version of that same portfolio. Not all investors have a meaningful bias to sell winners too soon and not sell losers so it is critical to get clear insight on this deterministic bias.
Analyzing investor, portfolio manager, and the congressional trading datasets we learned that not everyone displays the disposition effect. This occurs whenever there is little or no selling in the portfolio, in which case it is not “actively managed”. In these situations, more attention can be put on asset selection, fees, and portfolio weighting decisions to identify possible upside opportunities.
This is why we developed an investment workflow to debias investors and encourage the very behaviors and habits that reverse the disposition effect and lead to better performing portfolios.
The first step to determining whether a particular investor displays the disposition effect instead of assuming they do it. The majority of retail investors display some type of damaging bias, and this is one the most common and destructive.
Therefore we quantitatively evaluate each person’s historical trade decisions to quantify the degree of bias and also clarify whether the results stem from a spurious, low-frequency, non-systematic decision pattern (leading to a “false positive”) or whether an investor does indeed consistently sell winners too early and losers too late. To the untrained eye the results look the same, but we take the extra step to ensure that each investor is understood in their own light.
As any doctor, dentist, physical therapist, psychologist, and auto mechanic will tell you: diagnosis is not treatment.
So, if I have this tendency, how can I fix it?
Treatment & Prevention
Prescriptive financial advice is easy to give yet extremely difficult to follow, especially in the ‘heat of the moment’. This is one of the reasons that the Prof of Wall Street team and I developed a guided investment process designed to de-bias investors by reducing the frequency and severity of specific behaviors while encouraging constructive action.
This innovation is a guided investment decision workflow that provides a repeatable process for investors to follow and requires the investor to engage with the decision in a way that discourages biased investment decisions and/or inaction.
The disposition effect is driven by selling winning stocks (partly due to putting relatively more effort in the buying relative to selling according to an elegant paper by [Statman and Shefrin, 1985]).
Conclusion
So, what’s the key takeaway? Don’t let your emotions dictate your investment decisions. By understanding the disposition effect and utilizing tools like Prof of Wall Street to get personalized insights, you can begin to make more rational, data-driven choices. This isn’t about becoming a perfect, emotionless investor; it’s about recognizing your biases and taking steps to mitigate their negative impact.
Ready to stop cutting the flowers and watering the weeds? Start by taking a closer look at your trading history and see if the disposition effect is lurking in your portfolio. Your financial future might depend on it. Visit Prof of Wall Street to get started.