Why investors sell winners too early: the disposition effect
Many investors quickly book profits on shares that rise but hold on to shares that fall, hoping they will recover. This pattern has a name: the disposition effect. This page explains what it is, why it happens and how to manage it.
Quick answer
The disposition effect is the tendency of investors to sell shares that have gained in value too soon, while holding on to shares that have lost value for too long. It comes mainly from loss aversion, since selling a losing share makes the loss feel final. Over time, this habit can leave a portfolio full of weak holdings.
Key takeaways
- The disposition effect means selling winners and keeping losers.
- It is driven mainly by loss aversion and regret.
- The term was introduced by Shefrin and Statman in 1985.
- It can leave a portfolio full of weak shares.
- Rules based on current facts help reduce it.
What is the disposition effect?
It is a pattern in how investors treat gains and losses. People are quick to sell a share that is up, to lock in the good feeling of a gain. They are slow to sell a share that is down, because that would mean admitting a loss.
Economists Hersh Shefrin and Meir Statman named this pattern in 1985. Later studies of real brokerage accounts, including work by Terrance Odean in 1998, found the same behaviour among many ordinary investors.
Why does the disposition effect happen?
The main cause is loss aversion. A loss hurts more than an equal gain pleases, so people avoid the pain of selling at a loss. As long as the share is held, the loss feels like it is only 'on paper'.
Regret also plays a part. Selling a loser means accepting that the original decision was wrong. Anchoring to the purchase price adds to this, since investors wait for the price to come back to what they paid.
| Driver | Effect on behaviour |
|---|---|
| Loss aversion | Avoid selling at a loss |
| Regret | Avoid admitting a wrong choice |
| Anchoring | Wait to get back to the buy price |
| Pride | Enjoy booking a gain quickly |
Why is it costly?
If you keep cutting winners and holding losers, your portfolio slowly fills with weaker companies. Good businesses that may have grown further are sold early, while poor ones stay.
Tax rules can also make the habit costly. In many cases, booking a loss can be set off against gains under capital gains rules, while selling winners early can bring tax sooner. This is as per the rules at the time of writing, so please check the current position before you invest.
How to reduce the disposition effect
Judge each holding on what you know today. Ask whether you would buy the share now at its current price. If the answer is no, the purchase price should not be the reason to keep it.
Set clear exit rules before you buy, such as a stop loss for losers and a review process for winners. Regular portfolio rebalancing also forces you to look at every holding with fresh eyes.
The key point to remember
The disposition effect is a common habit that comes from how we feel about gains and losses. Knowing about it, and using rules based on current facts, can help you make more balanced decisions.
Frequently Asked Questions
What is the disposition effect in simple words?
The disposition effect is the habit of selling shares that have gained too early and holding shares that have lost too long.
What causes the disposition effect?
It is mainly caused by loss aversion, along with regret about a wrong choice and anchoring to the purchase price.
Who introduced the term disposition effect?
Economists Hersh Shefrin and Meir Statman introduced the term in a 1985 paper.
Why is the disposition effect bad for investors?
It can leave a portfolio full of weak shares, since winners are sold early and losers are kept, which can hurt long-term results.
How can I avoid the disposition effect?
Judge each holding on current facts, set exit rules before buying and review your portfolio on a regular schedule.
Disclaimer: Investments in the securities market are subject to market risks. Please read all related documents carefully before investing. This article is intended for informational and knowledge purposes only and should not be considered tax, financial, or investment advice. Tax laws and deductions may vary based on individual circumstances and regulatory changes. Readers are advised to consult a qualified tax advisor or financial professional before making any investment or tax planning decisions.
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