Definition
The disposition effect is investors' tendency to sell assets that have increased in value while keeping assets that have dropped in value. This behavior contradicts rational decision-making and creates poor portfolio outcomes - letting losses run while cutting gains short. The effect is driven by loss aversion, mental accounting, and the desire to avoid regret. Studies show the disposition effect reduces investor returns. Systematic rules, such as trailing stops and position time limits, can help counteract this bias.
Example
An investor owns two stocks: one up 30%, one down 30%. They sell the winner to 'lock in gains' while holding the loser hoping it recovers. The winner continues rising 50% more while the loser keeps falling.
FAQ
What is Disposition Effect?
The tendency to sell winners too early and hold losers too long.
Why is Disposition Effect important?
Disposition Effect helps investors evaluate behavioral finance and make more informed decisions.