Do you invest to make money? If you’re like most people, the answer will be a strong “YES.” Most people agree that having savings set aside for later is good, but earning a return on your investments is better.
Investing over the long term generally delivers returns. However, there are factors outside of your control that can influence your investment’s value in the short term. For example, market fluctuations, economic changes, and world events all affect how a particular investment performs.
However, outside factors aren’t the only influence on investment success. Individual investors’ choices also play a significant part. To improve your ability to make good decisions, researchers discovered multiple cognitive and emotional biases which can otherwise undermine investment success. Fortunately, understanding these behavioral finance biases helps you avoid them.
In this article, we dive into the disposition effect in behavioral finance, how it relates to the fear of loss, and how you can avoid falling into its trap.
The disposition effect refers to how, when, and why investors dispose of assets. It attempts to explain the general tendency of investors to sell assets that have made financial gains too soon while holding on to assets that are losing money. In short, it looks at why investors buy high and sell low.
You may ask why it might be a problem for investors to sell something that has made money? If you invest and see gains, that’s the whole purpose, right?
The problem is not selling after a stock rises in value but cutting returns short by taking profits too soon. Plus, once you’ve pulled out from a winning investment, it’s psychologically hard to buy back in at a higher rate.
Historical trends show that good-performing investments tend to continue to perform well, so they should be held. Particularly once an investment has some positive momentum, it can deliver significant gains.
Human psychology tells people that anything good won’t last forever. While that is generally true in the grand scheme of things, it does not help investors pick the right timing to sell a winning investment.
When you react emotionally rather than rationally, you may leave significant gains unrealized.
The second part of the disposition effect is the tendency of investors to hold onto an investment that is performing badly. You likely know this feeling because there isn’t an investor on the planet who hasn’t fallen for it at some point. It is that little voice inside that says, “If only you hold on, it might turn around.”
Rather than face the uncomfortable feeling of accepting losses, investors let the losing investment ride in the hope that it will recover. Naturally, there are times when you should hold an investment as it drops. If you have a well-selected portfolio during a market correction, consult with your financial advisor before liquidating any holdings, or you may miss out on the recovery.
However, the disposition effect is not referring to holding stocks during market corrections as much as individual investments that are not performing as expected. Perhaps you purchased too high, for the wrong reasons, or without solid fundamentals. In that case, the best thing to do is sell, recover your remaining funds, and reinvest elsewhere.
Fear is a significant driver of the disposition effect—especially fear of loss. The irony is that the fear of loss causes investors to lose more and gain less than they would if they took an informed and rational approach.
As fiduciary financial advisors in Minneapolis, we would never advise you to try and time the market. While there are appropriate times to make portfolio adjustments based on life events or market changes, with rare and notable exceptions, not even the most experienced and educated investors can consistently outsmart or outperform the market.
At the same time, a fair amount of your returns are determined by when you buy and sell an asset. If you buy at the bottom and ride it to the top, you’re going to see exciting returns. If you buy it at the top — that’s another story.
The disposition effect illustrates that even experienced investors will tend to cut their potential gains short and extend losses. This tendency explains, in part, why timing the market is so often unsuccessful. It also demonstrates why trusting your gut in the stock market is often a recipe for sub-par returns.
Knowing the disposition effect exists is the first step in overcoming it. However, even with the knowledge that your impulse to sell your on-fire stock is part of human psychology and not necessarily a sound plan, it’s hard to fight the impulse.
One study with investors discovered a loophole in the psychology of investing that counteracts the disposition effect. When investors were only managing their own investments, they were likely to sell winning investments too soon and hold losing investments too long.
However, when they were asked to consult on behalf of other investors, they were able to remove their emotions from the equation and approach the choices more rationally. The researchers hypothesized that it was harder to justify irrational decisions when participants had to explain them to other people.
If you don’t work with a fiduciary financial advisor and don’t have an experienced professional to help guide you through your investment choices, explaining your choices to another investor as if you were advising them on what to do may help get you out of the emotional response and into a more rational mindset.
Human instinct is powerful and, in many circumstances, will lead you in the right direction. Sometimes you may simply know the job, the people, or the actions that are right for you. However, for most people, trusting your gut in the investment markets traps you in inherent behavioral finance biases like the disposition effect.
Due to the complexity and changing nature of investment markets, the best approach you can take is a long-term, values-based strategy that connects your investment choices to meaningful life goals. This is why, at ViaWealth, we always start with who you are as a person and the life you want to enjoy before helping you craft a financial plan.