Have you ever clung to a losing investment with the hope of a turnaround? Or prematurely sold a profitable one just to secure the gains? If your answer is yes, you have experienced the disposition effect.
This behavioural bias inclines investors to prematurely dispose of assets that have appreciated in value, while persisting with those that have depreciated.
This behavioural tendency is often attributed to loss aversion and mental accounting. Investors are typically more affected by losses than they are delighted by equivalent gains. Holding onto a losing asset ward off the confirmation of a loss, instilling hope for a revival. Conversely, selling a profitable asset affirms a gain, leading to immediate satisfaction.
The disposition effect can result in poor investment decisions. It may cause investors to miss out on potential gains from profitable assets or endure bigger losses from depreciating ones.
Consider, for example, an investor who had purchased shares in Tesla during its early days of electric vehicle breakthroughs and then decided to sell during initial successes, motivated by the disposition effect. They would have missed out on the significant growth that followed. On the other hand, if they had invested in a once-thriving retail chain that began to struggle with the rise of e-commerce, clinging to these shares in the hope of recovery could lead to more substantial losses.
However, several strategies can help mitigate the disposition effect. As with all behavioural biases, the first step is awareness. Recognizing this bias can prompt investors to evaluate their motivations when deciding to hold or sell assets.
Formulating pre-set rules for when to retain or sell assets, based on objective criteria rather than emotional reactions, helps investors to make more logical decisions. Additionally, scaling in and out of investments rather than entering or exiting in full can minimize the disposition effect and reduce the risk of bad-luck timing.
By understanding and managing the disposition effect, investors can reduce the impact of emotional impulses, leading to more rational and consistent investment decisions.
