The Disposition Effect

Here’s a little quiz for you:

Let’s say you own 1000 shares of stock, valued at $10 per share, for a total value of $10,000.  Lets’ also assume 2 possible scenarios for the stock price the next day:

Question: One a scale of 1 to 7, rate your relative likelihood to sell or hold for each of the 2 scenarios below. For reference, the scale is as follows:

1 = definitely sell

2 = very likely to sell, small chance of holding

3 = somewhat more likely to sell than hold

4 = equal chance to sell or hold

5 = somewhat more likely to hold than sell

6 = very likely to hold, small chance of selling

7 = definitely hold

Scenario 1:  The stock goes up $0.50 to $10.50 per share, giving you a total value of $10,500.

What’s your answer, on the 1 to 7 scale?

Scenario 2:  The stock goes down $0.50 to $9.50 per share, giving you a total value of $9,500.

What’s your answer on the 1 to 7 scale?

Did you have a different answer for each scenario?

If your answer choice number was lower for Scenario 1 and higher for Scenario 2, you might be exhibiting what’s known as the Disposition Effect.

The Disposition Effect refers to the notion that many people have a tendency to sell stocks that increase in value a bit too quickly, while holding on to stocks that decline in value a bit too long.

This is rooted in the idea that it’s easy to capture gains, but painful to accept losses. When a stock drops in value, it becomes difficult to accept, and people are willing to hold out to make sure that their losses get recouped. I recall several people telling me about how they expected to make money on tech stocks around 2000, but started to lose money in a hurry. They held on, hoping to recoup their so-called “gains”. It didn’t happen, and people wasted a lot of time holding on to losers that eventually dropped further.

I have noticed a variation of this myself, thinking to back times when I played blackjack on a few trips to Las Vegas. I’m not at all a big gambler, and might wager $40 or $50 per day TOPS as purely entertainment. And I mean that’s the upper limit, as the odds are stacked against you. Anyway, if I started with $20 on a $2 minimum bet table, and won 3 hands in a row, I would want to pull away. Take my $6 in profit and run! However, if I lost 3 hands in a row, I would want to keep playing because I rationalized that things “had to even out”. I would stay in the game with $14 left. The odds as they are, you’re more likely to drop than get back to the original level. There is no measure of evening things out, on such a limited set of chances.

With stocks, it’s a different game than blackjack, of course, and there aren’t house odds that set against you. But the idea is that many people tend to sell the winners too quickly, and hold the losers too long. Instead of riding the momentum of a strong stock, people take profits and run. The same folks might hold on to a poorly performing stock, only to see it push down further after meeting some resistance.

Keep the Disposition Effect in mind, when deciding to sell stocks. Also, remember this concept when buying stocks as well; perhaps we can make money as others behave irrationally, and take advantage of opportunities? I’m more of an index fund person, but if you like to buy and sell stocks, it’s something to consider.

How about you?

Where did you rank in the quiz? Do you tend to exhibit any of these characteristics, or do you think you’re free of the Disposition Effect.

Comments

  1. Moneycone says

    For me it depends upon the strength of the company I’m investing in. When I bought Baidu, I was purely speculating (contrary to what pudits say, I have little faith in a company that simply apes another and is being propped up by the State) and would’ve sold if it started losing value. I sold it when it started making money as well, didn’t wait too long. But I would do the same for say, J&J. It sure is losing value, but it isn’t a loser.

    • Squirrelers says

      Moneycone – I can see how this can depend on the company. I can also see how some people can be predisposed to leaning one way or another, regardless of stock. We’re all different in this regard!

  2. Joe Plemon says

    Ray, great thought provoking post (as always). The disposition effect kicks in for me when I want to hold losers too long. My optimistic outlook on life can cloud reality in investments.

    • Squirrelers says

      Joe – thanks, glad you liked the post. Well, I have to say, having an optimistic outlook on life is a great thing – even if the disposition effect comes along as a part of the package.

  3. Roshawn @ Watson Inc says

    If you are really talking about individual stocks, I would be more likely to sell in the first scenario, as I good get my money out and diversify. However, if this scenario is expanded to include funds (i.e. index, ETFs, mutual), then I probably wouldn’t sell in either case (but still would be slightly more inclined to sell in scenario one).

    • Squirrelers says

      Shawn, that approach seems like it would be a sensible tendency for people to have. With stocks being more volatile individually vs. as a part of a collective fund. If I had to sell one way or another, I too would be more likely to move an individual stock quickly vs. a fund.

  4. Everyday Tips says

    If I was a daytrader, I would probably sell for both situations. Since I am not, I would probably hold regardless. (But more likely to sell for profit than sell to protect the amount I might lose.)

  5. Nicole says

    That’s one reason I like index funds. Just match the market and ride things out. Put money in regularly, take it out many years in the future on some sort of pre-planned schedule. Then I don’t have to worry about loss aversion or any other emotions.

  6. retirebyforty says

    I’m in the definitely hold for both scenario. I do tend to hold on to losers too long, but I sell them near the end of the years now to get tax deduction.
    I think 50c is too small of a swing. The quiz should be going from $10 to $12 pps.
    I can deal with 5% swing, no problem. 20% swing elicit a much more emotional response.

  7. Crystal @ BFS says

    I’m a long-term investor, so I answered 7 for both scenarios. We usually only sell when a stock goes up or down more than 10-20% since most of our money is made through the dividends anyway. :-)

  8. Jeff @ Sustainable Life Blog says

    Great post today – My answer was the same for each – I’d hold the stocks in both cases. It could be because I’m young and feel like I’ve got time on my investing side, but I also dont have many investments, so I dont have that much to compare with. I’ve only bought into the market once, and I bought at 8 dollars and sold at 24 (of course, I didnt have much money in there).

  9. Little House says

    I actually don’t really have this problem; I’m more likely to hold onto the “winners” and sell the “losers.” But I’m fairly new to investing in stocks, so maybe this is my reason. I learned early on that if a stock tanks and keeps on tanking, there’s only so much I can bear!

  10. Money Reasons says

    I answered 7 = definitely hold, for both. But it really depends on what the stock is doing and why it increased or decreased. Typically if the story and financials are still good, I hold. But if either the story or the financial, or some other game changer happened, I will sell.

    That said, after a stock doubles, I seriously think about taking out my money and letting the house’s money (the gain) run untouched. Sometimes I also use a percentage withdrawal to sell stocks in fifths or halves.

    Like MoneyCone, bidu has been a big winner for me, but I do believe in the stock (I did take my initial investment out though once it doubled), it has a great story and really has an unfair advantage.

  11. 101 Centavos says

    I guess 7 on both both scenarios. I tend to invest in natural resource stocks, which are highly volatile. As long as the fundamentals are right, then I usually sell if I’ve had a double. Dividend paying stocks are a different story. If the share price falls right before a payout, it just means the dividend buys a fraction more shares.

  12. Barb Friedberg says

    I really enjoy the behavioral finance aspect of finance and economics. It is so fascinating. I usually sell my losers and let my winners run. This research is actually based upon loss aversion which suggests that individuals feel pain more strongly than the they appreciate pleasure.

  13. Len Penzo says

    I used to agonize over when to sell a stock, and as a result I ended up second guessing myself after the fact. No more. All the guess work was removed because I now develop an exit strategy with regard to selling immediately after buying the stock.

    I sleep much better now.

    All the best,

    Len
    Len Penzo dot Com

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