The disposition effect is an anomaly discovered in behavioral finance. It relates to the tendency of investors to sell shares whose price has increased, while keeping assets that have dropped in value.
Investors are less willing to recognize losses (which they would be forced to do if they sold assets which had fallen in value), but are more willing to recognize gains. This is irrational behaviour, as the future performance of equity is unrelated to its purchase price. If anything, investors should be more likely to sell “losers” in order to exploit tax reductions on capital gains.
Investors would like to sell the winners and hold onto the losers as they are entirely emotional driven.
Basically, we feel better if we lock the gains and would not want to accept by selling the losers. They hold on to the losers at least until breakeven. This will result in holding assets that are losing in value.
I have seen people who hold on to a piece of real estate which is not moving up in value or making losses, but, instead when they need money, they will sell another piece of real estate which has moved up in value.
Rationally thinking they should sell the piece of real estate which is making losses, and invest them elsewhere to cover up the opportunity cost.
Moreover, these can also provide us tax breaks like, adjusting losses against capital gains.
Overcoming Disposition Effect
- Always look for opportunity cost and decide if we sell losing assets and invest in better ones
- Always include tax related rules in your buying and selling decisions
- Making rational decisions in all investments – reading a lot around behavioural finance and adjusting our behaviour while making investment decisions
During the 2008-09 financial melt-down, I had invested in stocks and mutual funds. During the stock market collapse, my overall portfolio was in red, and few of the stocks and mutual funds were riding high. I was fearful of losing the gains recorded on the high riding assets, and booked profits in them. For the ones in red, I decided to hold on until they break even. Few of them broke even, few were languishing in red and few went further down. Finally, I decided to clean up the portfolio, sold off everything, and rebuilt from scratch.
I am sure I have missed some great opportunities to invest in during this time like Nestle, Asian Paints, etc., But, from the booked profits I managed to pick few other great businesses at bargain prices like Maruti etc.,