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Tuesday 17 June 2014

D is for Disposition Effect

The Disposition Effect states that we're more likely to sell winners than losers but it also makes a more general statement. When things go well we tend to ascribe our success to our innate abilities - our disposition. When they go wrong we tend to blame external factors - our situation.  And the result is that we never learn very much.


One of the most famous examples is Terrance Odean's research into internet investors, Are Investors Reluctant to Realize Their Losses? which delivered the quite unequivocable answer "yes": the disposition effect costs the average investor in Odean's study of internet brokerage accounts about 4.4% a year. Which is a lot of money added up over a career. Although that career might be quite short if you don't stem those losses.


The standard reason given for the effect is that we behave differently in the presence of a loss to that of a gain - it's an outcome of Prospect Theory, the foundational theory of behavioral finance. There's not much agreement on this, however, and alternative suggestions center on feelings of regret and pride, mental accounting and a simple lack of self-control. Emotions are quite strongly implicated and, given that the behavior seems similar to that demonstrated by people outside of finance who consistently confuse disposition and situation (believing, for instance, that game show hosts are smart because they know the answers to the questions being asked), it's probably related to our need to generate a positive self-image for reasons of social status.

Whatever the reason it's a robust finding, so while psychologists are arguing among themselves about the causes we probably ought to try and mitigate its effects.


This is one behavioral bias that experience doesn't seem to help with, which is unsurprising if it's caused by deep-seated issues about personal status and self-image. So, in the great tradition of survivors everywhere, the best thing we can do is run away and hide. At the very least I'd recommend avoiding any tool that highlights your purchase price or your current gain or loss against that purchase price: this reduces the salience of that particular anchor and so mitigates its effect.

1 comment:

  1. Great start of a very promising series, please keep going!