The Disposition Effect — Selling Winners, Holding Losers

The disposition effect refers to the tendency to sell assets that have risen (winners) too early and to hold onto assets that have fallen (losers) too long.

The term was first coined in 1985 by two scholars, Hersh Shefrin and Meir Statman, in a paper titled 'the disposition to sell winners too early and ride losers too long.'

It's a strange habit when viewed rationally. Whether something will rise or fall from here has nothing to do with 'the price I bought it at.' Yet people tend to judge based not on future prospects but on 'whether it's a gain or a loss right now.'

The most famous evidence is behavioral finance scholar Terrance Odean's 1998 study from the early 2000s. He examined the actual trading records of about 10,000 accounts at a large discount brokerage from 1987 to 1993.

The result was clear. The rate at which investors realized (sold) profitable stocks was roughly 14.8%, while the rate at which they realized losing stocks was only about 9.8%. Put differently, investors sold profitable stocks about 50% more often than losing ones.

There was an interesting twist too. In December alone, the pattern flipped, and they realized more losses instead. This was 'tax-motivated selling,' where they lock in losses at year-end to reduce taxes.

The root lies in Daniel Kahneman and Amos Tversky's 'prospect theory' (1979). The core is loss aversion. People feel the pain of a loss far more strongly than the joy of a gain of the same size.

So to avoid the pain of the moment you 'confirm' a loss, you keep holding losers. As long as you don't sell, you soothe yourself that you 'haven't lost yet.' Conversely, with gains, you become anxious they'll vanish, so you rush to lock them in.

Add to this mental accounting that uses 'the price I bought at' as a baseline, and regret aversion from not wanting to admit a bad choice, and the habit becomes even more entrenched.

The problem is that this habit eats into actual performance. Studies analyzing Finnish investor data have estimated that the disposition effect was associated with a return loss of roughly 3.2%–5.7% per year. Moreover, holding losers for a long time lengthens the maximum drawdown and drawdown duration by that much.

There is no perfect solution, but the direction is clear. First, judge based not on the purchase price but on 'whether this asset is still worth holding going forward.' Second, set rules before emotion intervenes (e.g., recurring investing that puts in the same amount at regular intervals). Third, look at how the whole portfolio flows when held for a long time, rather than the wins and losses of individual stocks.

When you see with your own eyes, using actual historical data, how different 'holding long' and 'selling' turn out, you can view the emotion of loss aversion with a step back.