The disposition effect could be an investor’s greatest enemy

The disposition effect refers to an anomaly in behavioural finance where investors tend to sell winners early and hold onto losers longer.

While many investing textbooks point towards using fundamental data to drive decisions, investors, let emotional sentiment drive their choices. There are at least four different studies between 1985 and today proving without a doubt that investors are likely to sell their best, winning stocks while buying more and holding onto losers. Let me explain why…

Why does the disposition effect drive our decisions?

To put it simply, when we sell a position and realize a gain it in turn proves that our initial decision to purchase this stock was correct.

On the other hand, when one of our holdings has an unrealized loss, selling that position would prove that we made a bad decision by picking that stock.

This explains why it is easier to sell a winner and why we tend to hold onto losers longer.

What’s more, investors also react far worse to a losing trade than the enjoyment gained from a winning one.

So, a 15% loss is more emotionally damaging than the joy in experiencing a 30% profit.

How can you change your behaviour to make less emotional decisions and neutralise the dsposition effect?

Behaviour change # 1 – Start at the beginning

Avoiding emotional selling can start by avoiding emotional buying…

You need to ensure that you do thorough research before buying a share. Decide at what level you will buy, and decide in what cases you will sell the share – beforehand.

This way it is easier to live with your decision.

Behaviour change # 2 – Sit back and do less

We tend to become fixated on share prices. Opening our browsers every five minutes to see what a share has done.

You should avoid this behaviour at all costs.

Rather check your portfolio once a week – and set up alerts for news coming out. That way you only check up when there’s something relevant.

But still remember – never react to the news unless it affects your reason for holding the stock.

Behaviour change #3 – Buy stocks you can hold forever

If you buy a share you are happy to hold forever – there’s no reason to sell. Think a dividend payer with long term prospects.

If you get paid dividends for holding the company, why worry if the share price has dropped today, or risen tomorrow?

While a buy and hold approach isn’t always appropriate – it does work especially when you hold on to your best winners over time…

Behaviour Change #4 – Don’t invest with money you need

You should never invest with money you need to get access to in the coming 12 – 24 months.

In fact, you should try not investing with money you can’t afford to lose.

If you do, it will raise your stress levels and the likelihood of making emotional decisions.

What are the reasons to sell a stock?

Deciding when to take profits on a winning stock can be an agonizing decision. Since no one knows exactly when a stock has hit its highest price, you should sell your stock when it makes sense to you.

Factors to consider, include your original investment objective, your personal tolerance for risk and whether anything about the company has changed.

If you’re not a buy and hold investor you can set up selling criteria such as:

• Price targets: Whether this is to the downside or upside – you should determine these upfront when buying the stock and try to periodically review these levels.

• Changing business case: If a company you own no longer meets your criteria or its business case deteriorated – it could be a clear selling signal.

• Tax considerations: Sometimes holding on to a winner for a bit longer could mean the tax you pay on it changes from income tax to lower capital gains tax. Similarly – selling a loser just before tax year-end could
benefit you. Tax alone isn’t the only criteria to make selling decisions on – but it should play a role.

The simple fact is there is no ‘one answer fits all’ solution when it comes to investing. What your goals are, your financial situation and other factors will always play a role.

But if there is one rule I live by, it is to quit relying on simplistic stock market sayings and rules of thumb and instead get my hands dirty researching and learning about the companies I invest in.