Disposition Effect and Loss Aversion

Try this exercise: Take a moment and think about a stock you used to own or still own that went down

90 percent. Consider why you didn’t sell after it dropped 10 percent to cut your losses. Sure, hindsight makes the answer obvious. The signs to sell were there, but you missed them. At the time, you probably said to yourself, “It’s bound to come back up. This is only a temporary dip in price, and I’m in it for the long term.”

On the other hand, think about a stock you sold after it went up 15 percent. You were thrilled to have locked in the profit — until you started watching that stock grow into the next 1,000 percent gainer. Today, you beat yourself up as you consider all the money you didn’t make because you sold too soon.

Rest assured that you’re not alone if you can relate to either or both of these scenarios. There are two powerful cognitive biases working against investors: the Disposition Effect and Loss Aversion.

The Disposition Effect is the tendency to sell assets that have increased in value and hold on to assets that have decreased in value. Why do we tend to sell after a profit? One reason may be that by doing so, we’re sure to feel good about our initial purchase. We can sit back and enjoy the feeling from making a winning purchase. Conversely, we hold on to trailing assets too long. Selling it feels like admitting that our initial instincts and reasoning were wrong.

This bias is linked to another human tendency, Loss Aversion. Simply put, people often demand much more to give up an object than they are willing to acquire it for.

For example, you pay $10,000 for something. A few months later, somebody offers you $9,000 for it. You say, “No way, I just paid $10,000. It can’t be worth only $9,000.” You mentally dig your heels in and hold your position for as long as possible because it’s hard to admit you’re wrong. This is what happens when you buy a stock and the price starts dropping. Other investors aren’t willing to pay the price you paid, and the price continues to fall.

How do you overcome these biases? Being aware of them and understanding that they influence your thinking is an important step. It’s equally critical to develop a systemic, non-emotional investing process with well-defined rules that can be applied to the downside protection of your investments as well to letting winners run.

Disciplined, self-aware, and unbiased: good qualities in life, great in investing.