Disposition Effect

The term was introduced by economists Hersh Shefrin and Meir Statman in 1985. It is linked to loss aversion and to how people mentally frame gains and losses. Selling a winner feels good because it locks in a gain, while selling a loser feels painful because it turns a paper loss into a real one.

For example, an investor holds two shares, one up 30% and one down 30%. Needing cash, they sell the winner, even though the business behind the loser has weakened, because selling the loser would mean admitting a mistake.

This behaviour can hurt returns. Research suggests that the winners investors sell often keep performing well, while the losers they hold often keep doing poorly. It can also be tax-inefficient, since realizing gains creates tax while realizing losses could reduce it.

A useful test is to ask, for each holding, whether one would buy it today at the current price. Setting rules in advance for when to sell can also reduce the influence of emotions.