When investors decide whether to buy or sell a stock, they often get sucked into the “disposition effect.”
Professors Hersh Shefrin and Meir Statman, who first invented this concept in 1985, define it as “investors’ disposition to sell winners too early and ride losers too long.” If you were trying to decide which of two stocks you should sell in order raise some cash, you may decide to sell the most profitable one, and enjoy the fruits of your gains. This decision is a prime example of the disposition effect.
Don’t be fooled
Many investors don’t realize is that may actually be better to dump the losing stock because you would receive a tax benefit of selling at a loss, and get to keep your better stocks.
Why is it easy to fall for the disposition effect?
Emotions. The reason is that an investor who bases his financial decisions on the satisfaction that he feels on making a profit from a winning stock is following his emotions rather than logic. Rather than making emotional financial decisions, look at the merits of each individual stock. When assessing whether a stock is profitable, don’t just look at short-term gains, but look at the bigger picture. Could this “winning” stock be an even greater winner if you hold onto it a little longer, or is it time to sell?
Remember every financial move that you make is a decision – even if your decision is to to leave everything status quo. Avoid the disposition effect, and make all of your decisions carefully, based on logic and common sense. If you aren’t sure whether you are able to look at each investment and reach a rational decision, call your financial advisor for help.