In my recent X post from late December I teased, I would write an introductory article taking a stab at the infamous disposition effect – a prominent behavioural bias in finance often driving – at least partially – bad investment decisions (there's a remedy, so fear not). Let's fly by this bias and get a good look at it!
The bias expresses the irrational, persistent tendency of cryptocurrency and stock market investors to prematurely sell assets that have increased in value, while stubbornly clinging to those that have lost value, relative to the initial investment cost. This cognitive phenomenon has significant implications for the overall investment outcomes, often hindering many inexperienced investors from maximizing their returns.
The driving force behind the tendency
At the core of the disposition effect lies another driving force, a bias called loss aversion, which is a fundamental principle of the Prospect Theory, developed by the fathers of the field of Behavioural Economics, Daniel Kahneman and Amos Tversky. The basic premise of a loss aversion is that you perceive the subjective pain of a loss more intensely than the pleasure of a gain in the value by the same amount.
For example, investors with a portfolio of crypto or stocks (or both) equal to $10 000 in value, will, on average, perceive the disutility value function of a loss of, say, $2000 against their portfolio value as twice as large as an equivalent utility value of a gain of $2000 against the very same portfolio. Given the above fact, it's only natural you focus more on how to avoid the disutility of realised losses, than the realised gains!
This striking experiential asymmetry in your subjective response to realised gains and losses influences your investment decision making ability. When you sell an investment, even at a modest gain, you are likely to experience that you've "locked in" a tidy profit, which provides to your mind a sense of a relief and accomplishment, and, at the same time, lets you avoid the risk of potential future losses with respect to that stock or crypto. This side of loss aversion often drives beginner investors, both in the stock and crypto markets, to sell winners prematurely, thus potentially missing out on substantial future growth resulting from CAGR.
Conversely, (desperately) holding – often for a potentially indeterminate time interval – onto unrealised losses can become with time emotionally challenging, distract your ability to focus and, in consequence, worsen an overall performance in other areas of life. Admitting to a loss, therefore a bad investment decision, can impart on your self-esteem and perceived shrewdness, pushing you to cling to the hope of a future crypto or stock recovery – again, at some indeterminate time interval – even if the underlying fundamentals of the asset might have significantly worsened.
This "hope bias" is further exacerbated by a cognitive dissonance, a mental state where you may have been holding simultaneously onto two orthogonal beliefs about your assets. Holding persistently onto a losing investment may allow you to maintain the illusion that your initial investment decision was, in fact, correct, thus reducing or even nullifying the cognitive dissonance that would arise from admitting to yourself that a mistake was made and it's time to pull the plug.
The bad, the good and how to reduce the bias
The consequences of the disposition effect can be substantial, even gargantuan in the long run. If you sell prematurely winning crypto, stocks, ETFs, etc., you will miss out on the powerful force of compounding returns (CAGR), a key driver of a long-term wealth growth. Conversely, if you hold onto losing investments for too long, you will allow losses to keep accumulating, eroding your portfolio's value and possibly decreasing the opportunity cost for faster recovery, thus hindering your overall financial goals.
So how can you, at least partially, debias your decision making and reduce the overall impact of the disposition effect? The good news is that, according to Huang & Guenther, the mere intervention of informing individuals about the effect is impactful, reducing the negative consequences. Apart from that, you could try to develop a well-defined investment plan, implement and stick to stop-loss orders, conduct regular portfolio reviews, focus on the fundamentals of the underlying cryptos and stocks, and also learn and cultivate an emotional detachment, exemplified, among other philosophies, by Stoicism.
These are crucial steps that can help you mitigating the impact of this pervasive bias. By understanding the psychological underpinnings of the disposition effect and by implementing strategies to counteract its influence, you stand a chance at making more rational and effective decisions in your investment journey, ultimately improving your long-term financial outcomes for yourself and your loved ones.
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