Why We Can't Let Go: the Psychology Behind the Disposition Effect

 

The Disposition Effect

 

Have you ever found yourself in the middle of a stock market nightmare, gripping onto a losing stock like a desperate ex-boyfriend who just can't let go? You know it's not good for you. You know it's not going to work out. But you can't help but hold on, convinced that one day, that stock will bounce back and make everything better. And then, in the end, the stock just keeps plummeting, leaving you feeling like an idiot.

 

On the flip side, have you ever sold a stock that was doing great, just because you were too anxious to lock in your gains? You sell it, and then watch as the stock keeps climbing, and you're left kicking yourself for not holding on just a little longer.

 

If you've ever found yourself in either of these situations, you're in good company. This phenomenon takes the name of disposition effect, and it's a common behavioral bias that affects investors of all levels of experience. 

 

The disposition effect was first coined in 1985 by Shefrin and Statman, who studied how individual investors' behavior towards gains and losses realization was affected by an anomaly that systematically diverges from the optimal strategy. Simply put, people tend to hold onto losing assets for too long, while selling winning assets too early.

 

Prospect Theory as theoretical framework

 

The theory that the authors used to explain the disposition effect is Kahneman and Tversky's prospect theory. Its S-shaped utility function is concave for gains and convex for losses, which suggests that people are risk-averse when it comes to gains, but risk-seeking when it comes to losses. In other words, we're more likely to hold onto a losing stock in the hopes that it will recover, while feeling anxious to lock in a gain from a winning stock.

 

However, this theory doesn't always do a great job of explaining the disposition effect. For example, research by Markku Kaustia (2010) has shown that the empirical propensity to sell a stock is increasing or approximately constant as the gain increases, whereas prospect theory value function predicts that it will decline as the gain increases. This suggests that there may be other factors at play when it comes to the disposition effect. 

Another hint of the fact that prospect theory is unlikely to explain the disposition effect is the fact that the trend reverses in mutual funds: investors exhibit greater propensity to sell losing funds compared to winning funds.  If this contradicts the predictions of prospect theory, it aligns quite well with another explanation of the disposition effect: cognitive dissonance.

 

The role of Cognitive Dissonance

 

Cognitive dissonance is the discomfort that people feel when their beliefs clash with new, contrasting information. In the case of the disposition effect, this discomfort may arise when an investor's belief that they made a good investment choice is contradicted by the fact that they're losing money on the position. This can lead to the investor holding onto the losing asset for too long in an attempt to avoid the discomfort of realizing a loss. 

 

But something different happens when we delegate the decision-making about investment to an outside agent, like what happens with actively managed mutual funds. Now, the same discomfort caused by a loss on the position can be resolved by blaming the manager, the agent who got his investment choices wrong, with our only fault being having put trust in someone who is untrustworthy. This will naturally result in the selling of the asset. Hence, the reverse-disposition effect investors exhibit for delegated assets.

 

The 2016 research by Chang, Solomon, and Westerfield has tested this hypothesis in an exciting paper which makes use of two experiments: the Fire treatment and the Story treatment. The Fire treatment was designed to increase the saliency of the fund’s manager role, replacing the words "Buy," "Sell," and "Portfolio performance/gain/loss" with "Hire," "Fire," and "Fund Manager's performance/gain/loss." The story treatment, on the other hand, was designed to increase subjects’ cognitive dissonance, with the subjects being reminded of the reasons they had previously stated for purchasing a certain stock when they were considering selling it.

 

The results were crystal clear: increasing the level of cognitive dissonance amplifies the disposition effect for non-delegated assets and strengthens the reverse-disposition effect for mutual funds.

 

Overall, it seems that cognitive dissonance may provide a better explanation for the disposition effect than prospect theory. This highlights the importance of understanding and being aware of our own behavioral biases when it comes to investing. By recognizing the tendency to hold onto losers and sell winners too early, we can take steps to counteract this bias and make more rational investment decisions.

 

So, the next time you find yourself holding onto a losing stock for dear life, or selling a winning stock too early, remember: you're likely falling victim to your own cognitive dissonance. And, just like every other behavioral bias, getting rid of it is impossible, it’s just how our brains are wired. But by understanding it, and being aware of it, you may be able to take steps to overcome it. Maybe, after this read, you'll have the insight to re-evaluate your poor investment choices and have the strength to cut your losses and, finally, move on.

Key takeaways 

• The disposition effect is the tendency to hold onto losing assets for too long and sell winning assets too early
• Prospect theory is unlikely to explain it
• Mutual funds present a reverse-disposition effect, where investors are more likely to sell losing funds compared to winning funds 
• Cognitive dissonance seems to be an important driver of the disposition effect