Fighting the Disposition Effect
The disposition effect is an investing bias that refers to our tendency to prematurely sell assets that have made financial gains, while holding on to assets that are losing money.
We are driven to sell our winning investments to ensure a profit but are averse to selling losing investments in hopes of turning them into gains.
The disposition effect is an investing bias that hurts our returns. This post describes what causes disposition bias and suggests some ways investors can fight it.
A Common Bias
There’s an old trader’s adage that says, “let your profits run, and cut your losses”.
It feels good to be right and bad to be wrong. It feels good when we make money and bad when we lose it. Everyone feels this way. Unfortunately, these emotions can cloud our investing judgement. Disposition bias causes us to sell our best investments too early and keep the worst ones instead.
If you’re holding onto bad investments in the vain hope that they will somehow eventually recover, or if you’re selling your best investments only to see them continue to rise further, this post is for you.
The Causes of Disposition Bias:
- Sunk Cost Fallacies
- Mental Accounting
- Commitment Bias
- Our Pride & Fear
Cause #1 – Sunk Cost Fallacy
Disposition bias aligns with the sunk cost fallacy, which is our tendency to continue funneling resources towards losing investments instead of successful ones. Since we already have resources invested in the outcome, the Sunk Cost Fallacy causes us to commit more resources to bad investments simply because of our past actions.
We are likely to continue an endeavor if we’ve already invested in it, whether it be a monetary investment or the effort that we put into the decision. It often means we go against evidence that shows its no longer the best decision.
Cause #2 – Mental Accounting
While we manage physical accounts for our finances, we also keep intangible mental accounts. Mental accounting causes us to view each investment in isolation and to make our decisions based on the state of the account at hand rather than our whole portfolio.
We also attach emotions to these accounts. Instead of selling bad investments to realize their losses, we oftentimes hold onto these investments in the vain hope they will recover. Worse still, we sometimes add to our losing investments, putting “good money after bad”.
The way to fight mental accounting bias is to put decisions into context by considering facts instead of emotions. Make investment decisions in a process-oriented way and analyze your entire portfolio, not just single investments in isolation.
Cause #3 – Commitment Bias
Commitment bias describes our tendency to remain committed to our past behaviors, particularly those exhibited publicly, even if they do not have desirable outcomes.
Not only do we attempt to justify our behaviors to ourselves, but we also try to make others see our behaviors as rational too. To save face, we may defend our behavior to others by trying to convince them that the choice we made was not a bad one after all. We may suggest that, while the immediate outcome was unfavorable, this decision will be beneficial in the long term.
The objective truth is that when you take investment risks, sometimes you win, and sometimes you lose. Admitting this to yourself and others is a healthy exercise.
Cause #4 – Pride & Fear
Fear of regret is powerful. The disposition effect echoes many regret anxieties.
“What if I sell a losing stock right before it takes off?”
“If I sell now, I may miss out on future gains.”
“If I sell now, I’ll be admitting defeat.”
What commitment bias comes down to is that we are constantly trying to convince ourselves and others that we are rational decision-makers. We do so by maintaining consistency in our actions, as well as by defending our decisions to the people around us, as we feel that this will give us more credence.
We fail to consider that whatever time, effort or money that we have already expended will not be recovered. We end up making decisions based on past costs instead of present and future costs and benefits, which are the only ones that rationally should make a difference.
Bad Investors, Good Investors
Many investors are subject to disposition bias. As much as we like to feel logical and rational, we make many decisions driven by fear, pride, and emotional misconceptions. With this in mind, what are the differences between bad investors and good investors?
Bad investors do armchair analysis, invest with emotion, and let psychological bias impact their decisions. Good investors follow their plans, make decisions based on facts, and focus on long-run outcomes.
Avoiding psychological bias means your decisions must be based on facts, not emotions. Financial performance must be grounded in a comprehensive point of view expressed in a financial plan, rather than “shooting from the hip”.
Tax Advice?
Tax policies also increase the costs of the disposition effect. Because selling a losing investment will realize capital losses and selling winning investments will realize capital gains. Therefore, taxes are another important incentive for us to re-examine how we approach losses and gains. Consequently, it is more profitable to realize our losses than our gains because it will reduce our tax burden.
Tips for Improvement
If you’re prone to disposition bias, by holding on to your losing investments, here are some ways you can improve:
You Win Some, You Lose Some
Begin by realizing that when you take investment risks, not all your investment decisions will be “winners”. Some of your decisions will be profitable and some of your decisions will turn out badly. We’re all human and nobody is perfect. Admitting this to yourself and others is a good way to begin focusing on tangible ways to improve your portfolio instead of making excuses.
Save Face
Oftentimes, its better to admit when you’re wrong, rather than make excuses or blame others. You’re more likely to gain the respect of others when they can see you’re a rational decision maker and emotionally intelligent. So, when you make bad decisions or when your judgement is clouded by emotions, tackle those biases head on.
Have a Plan
A great way to fight emotional investing is to rely on a written plan to guide your decisions. Having a plan will help anchor your decisions in facts. Without a plan, investors are much more likely to fall victim to guesswork. Having financial plans helps put your decisions into context and helps your advisors support you.
Think Long-Term
The day-to-day ups and downs of financial markets can be emotionally draining – if you let them. Don’t get caught up in the headlines. Instead, focus on your long-term goals and regularly evaluate your progress in a systematic way. A good rule of thumb is to review your financial position on a quarterly basis. If done consistently, this will help you refocus on long-term results over years instead of the emotions that come with the day-to-day gyrations of markets.
Evaluate your portfolio without considering unrealized gains & losses
Since disposition bias is connected to “sunk cost fallacies”. So stop evaluating your portfolio using unrealized gain & loss reports. Many investment advisors/brokerages give clients reports showing how much individual holdings are up or down. While these facts are useful when making tax decisions, whether an investment is up or down since you purchased it should have no impact on your decisions for the future. So, try evaluating your portfolio based on other factors instead. Doing so will help you fight mental accounting and the disposition bias.
Family Office Advantage
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