Disposition effect

Ask an investor which holding to sell and the answer is very often the one that is up. The one that is down stays — "it will come back".

Shefrin and Statman (1985) called this the disposition effect. In the workbook's quotation, "people dislike incurring losses much more than they enjoy making gains, and people are willing to gamble in the domain of losses". Consequently "investors will hold onto stocks that have lost value and will be eager to sell stocks that have risen in value."

Selling a loser makes a paper loss real, and that hurts. Selling a winner locks in a gain, and that feels good. Neither feeling says anything about which stock has the better prospects from here.

The workbook places the disposition effect under loss aversion bias, one of the emotional biases: people prefer taking chances to avoid losses but do not like taking chances with certain gains, and losses are significantly more powerful than gains. That is prospect theory's premise that people are risk-averse about gains and risk-seeking about losses, showing up in portfolio decisions.

It has a market-wide consequence too. In Chapter 14's section on anomalies, the workbook says the disposition effect — investors holding on to losers longer and selling winners faster — explains momentum in prices. If good news is sold into early, prices underreact and keep drifting up afterwards; if bad news is held through, prices take longer to fall to where they belong.

The workbook's general remedy for biases applies: it is impossible to be unbiased, but discipline and checklists help mitigate them.

Illustrative figures. Anjali holds two stocks, each bought for ₹5 lakh. She needs ₹6 lakh for a home down payment.

She sells A — "take the profit" — and keeps B — "I'll sell when it gets back to ₹5 lakh."

Both reasons refer to her purchase price, which the market neither knows nor cares about. The relevant question is: which stock would she buy today with ₹6 lakh? If her honest answer is "A", the disposition effect just made her sell the business she prefers and keep the one she does not.

A year later, suppose A rises another 15% and B falls another 20%. The stock she kept, B, is now worth ₹2.8 lakh — down another ₹70,000. The stock she sold, A, would have been worth ₹6.9 lakh — up ₹90,000. The loss she avoided realising on B was paid for in real rupees.

Chapter 14 (Behavioural Finance), section 14.3.1, introduces the disposition effect under loss aversion bias with the Shefrin and Statman quotation; section 14.5.1 uses it to explain momentum in prices. It connects to prospect theory (section 14.2.2) and to the momentum strategies of Chapter 18.

• Sell winners too early, hold losers too long — the order is the whole definition.
• Shefrin and Statman, 1985. Prospect theory is Kahneman and Tversky, 1979.
• It is filed under loss aversion, an emotional bias in the workbook — not under cognitive errors.
• It explains momentum, according to the workbook — not the January effect or the size anomaly.
• The purchase price is a reference point, not information. Disposition effect and anchoring often appear together, but anchoring is a cognitive error about relying on initial information; the disposition effect is about realising gains versus losses.