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.