Why the Disposition Effect Can Make You Sell the Wrong Stock

Why the Disposition Effect Can Make You Sell the Wrong Stock

If you are thinking of selling an investment, beware of the disposition effect. This occurs when investors hold onto their losing investments for too long and sell their winners too soon. The disposition effect often causes investors to sell the wrong investment.

What should you sell?

If you need to sell one of your investments, which one should you choose? Should you sell a stock that has made a profit, or should you sell an underperforming stock that has dropped?

The disposition effect occurs when you automatically sell (dispose of) your most profitable investment and keep your losers as a matter of principle rather than as a reasoned decision.

Why would you do that? Perhaps you think that you’ve gotten the most out of the stock, and you hope that the poorly performing investment may make a profit eventually. This is an erroneous assumption.

Professor Terrance Odean of the University of California researched the trading patterns of tens of thousands of investors, and found that people sell winning investments because they like the feeling of selling at a profit; it provides lots of “bragging rights” as they can tell their friends that they made an amazing profit on the stock market, even though according to logic, it may have been better to dump the least profitable stock. By selling the loser, they can get a tax benefit from selling at a loss, and their winning stock may make them even more money if they hold onto it. Yet the satisfaction from profiting from a winner blinds them to the real benefits they may derive from selling your loser.

Follow your logic rather than your feelings

The best way to fight the disposition effect and make the right decision is to look at each stock based on its own merits. Follow logic, rather than emotions. Examine factors such as company performance (not only the performance of the stock) and consider the long term, rather than simply looking at recent events. Don’t be dazzled by famous names. Even large companies can crumble. Remember Lehman Brothers, Bear Stearns, WorldCom, Enron, and other big names?

Watch this three-minute video from the Rich As A King bonus videos for more advice on how to decide which investment you should sell. It will help you to avoid the pitfalls of the disposition effect.

Douglas Goldstein, co-author of Rich As A King: How the Wisdom of Chess Can Make You A Grandmaster of Investing, is an avid chess fan, international investment advisor and Certified Financial Planner (CFP®).

 

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