Disposition Effect

What is the disposition effect?

The disposition effect is investors’ tendency to sell winners more readily than losers, usually judged against the price they paid. Shefrin and Statman named the pattern in 1985; Odean (1998) later examined it in 10,000 brokerage accounts.

The disposition effect in behavioral finance

Investors sold more winners than losers, even after checks for portfolio rebalancing and stock-price-related trading costs. In that sample, the losers they kept subsequently performed worse than the winners they sold.

Odean discussed several possible explanations, including prospect theory and mistaken expectations that losing stocks would rebound. The trading pattern alone does not tell us which explanation caused it.

A disposition effect example

Imagine two holdings bought for $100 each. One is now worth $120 and the other $80. An investor feels ready to sell the winner to secure its $20 gain, but wants to keep the loser until it returns to $100. That illustrates the tendency to realize gains more readily than losses. It does not establish that either trade is wrong: the holdings' prospects and the investor's circumstances could justify different decisions.

Mental accounting is one proposed explanation discussed by Odean. An investor may treat each purchase as a separate account, using its purchase price to decide whether it has succeeded. Selling the $80 holding would close that account with a loss; keeping it open preserves the possibility of breaking even. This can make the original price psychologically important, even though it does not by itself determine the holding's future return. The example illustrates the hypothesis, not a cause established for every investor.

Why it matters

The price you paid can become a reference point for deciding whether to sell. But a gain or loss since purchase is only part of that decision: expected returns, taxes, risk, and costs also matter. Selling a winner is not automatically a mistake.

For a related idea about avoiding decisions that might feel wrong later, see regret aversion.