Disposition Effect- why we want to hold on to our lose making investments
A regret aversive nature makes you hold on to your losses and sell profit-making assets.
The disposition effect is our inclination to prematurely sell assets that have made financial gains while holding on to losing money assets. We seek to sell our winning investments to secure profit but are averse to selling losing investments in hopes of turning them into gains. When good news is announced, the price of an asset does not immediately rise to its value because of premature selling or lack of buying. Similarly, when bad news is revealed, the price falls less because investors are reluctant to sell. It is another explanation for why prices might underreact and significantly impact the momentum premium. A mental approach called “hedonic framing” can minimize the disposition effect. The objective of this division is to maximize psychological pleasure and reduce pain (regret).
This effect aligns with the sunk cost fallacy, our inclination to continue funneling resources, whether time, money, or material, towards a losing investment.
Hersh Shefrin and Meir Statman framed this concept; professors at Santa Clara University, US, used the above question to test this psychological pitfall. Their hypothesis has its fundamentals ingrained in the prospect theory by Israeli psychologists Daniel Kahneman and Amos Tversky.
The two scientists blame this inclination to deepen losses and lock in early gains on the regret-aversive nature of investors. The psychology responsible for holding losing security believes that it will bounce back someday. Also, people are reluctant to admit an error of judgment and are ready to gamble on the downside. The positive counterpart of regret is pride; they are quick to book profits to prove the accuracy of their decisions.
As a result, they sell winners and hold on to their losers. They are satisfied psychologically, only to be penalized by the stock market. In a paper, ‘Are investors reluctant to realize their losses?’ Terrance Odean, a professor at the University of California, further explores this behavioral flaw among individuals.
The disposition effect can genuinely reduce the awareness of its pitfalls. Understanding how letting go of losers and holding on to winners ultimately benefits us long-term can incentivize us to unlearn our costly disposition. If we can understand this in the realm of investments, we can bring this knowledge to other areas of our personal and professional lives: projects, relationships, and more.
