Diogo Gonçalves

There is one behavioral bias that I’ve been fighting hard to battle since i started investing seven years ago.

Two economists coined the term “the disposition effect” in 1985: Hersh Shefrin and Meir Statman.

It’s a well-documented tendency for investors to sell winners too early and hold losers for too long. You can also find real data studies done by Terrance Odean.

In his 1998 paper “Are Investors Reluctant to Realize Their Losses?”, Odean analyzed real trading records from a large U.S discount brokerage firm that confirm this evidence.

Why We Do It

There are several psychologic factors that contribute to this.

Loss aversion, as identified by Kahneman and Tversky, means that loses generally are more intensely felt than equivalent gains. I recommend reading as much of their work as you can if you are serious about being good at allocating capital. Humans are by nature risk averse and hate losses. Realizing a loss of €1,000 gives you more pain than a gaining of a same amount.

Selling a loss also means admitting a mistake. As long as the position is still on, investors stay in a denial state, no matter the prospects of that investment to bounce back.

On the winner’s side, investors also want to close the positions to lock the position effect they are feeling, and get a dopamine hit.

None of that matters for the future returns.

The market does not know your purchase price.

It does not care whether you are up 50% or down 30%.

Your purchase price contains no information about future returns, but we carry all that baggage with us when we make a judgment today about the future.

Peter lynch once used a beautiful analogy to talk about this: selling your winners and buy more of your losers is like cutting the flowers to water the weeds.

The disposition effect has been one of the hardest biases for me to overcome. Even after seven years of investing, I still catch myself feeling it. Awareness helps, but it doesn’t eliminate the problem. Most biases don’t disappear simply because we understand them. If anything, they become more subtle. I’ve learned that trying to fight them through willpower alone rarely works. What works is building a process that makes it harder to act on them.

Experience helps, because every time a decision like that results in worse outcomes, you gain scars that help you decide next time. However, one will never fully be able to remove it completely. Professional investors also experience this, just to a lesser extent.

The disposition effect is one reason momentum exists

One of the most fascinating ideas in behavioral finance is that the disposition effect may help explain part of the momentum effect.

I don’t have enough data and information to confirm this, but the disposition effect may contribute to it. If investors sell to soon, and hold losers longer than they should, prices adjust lower than reality. That may be one reason why stocks that go up continue going up for a while, because investor forces are contributing to a slower correction to the new reality. The same happens on the downside. Denial is making it grind more slowing to the current lower price a stock should have.

Whether this effect is large enough to explain momentum on its own is debatable, but it illustrates an important point: behavioral biases do not only influence individual investors. When enough people share the same bias, that behavior can influence market outcomes.

This is also one reason that being able to overcome the disposition effect brings real alpha in an investment process.

Awareness alone has not been enough for me. The best way I have found to deal with the disposition effect is to build a process that makes it harder to act emotionally. I believe I have become better at managing the bias over time, and these are the three practices that have helped me most.

1. Create a written sell checklist and keep a sale journal

Every time I sell a position, I write down exactly why I’m selling it and what I expect the business to look like in five years.

A journal creates accountability. It prevents me from rewriting history later and allows me to review whether my reasons were actually correct. It also helps me distinguish a bad outcome from a bad decision. Those are not the same thing.

2. Never take a decision when a company releases earnings or some news

Earnings releases are emotional events. A stock drops 15% and suddenly every risk looks obvious. A stock jumps 20% and suddenly every concern disappears.

Take your time to digest the news or the earnings. Never execute any action when emotions are still fresh. The extra time rarely costs me anything, but it dramatically improves the quality of my thinking.

You want to create friction between emotion and action. Prevent a temporary fear, relif or excitement from becoming a permanent decision.

This will also prevent the tendency to trade often. Most quarterly results and news alone do not change the long-term prospects of the business.

3. Reframe every position from scratch

Every few months, I try to look at my portfolio as if I had never owned any of the businesses. If I had a portfolio made entirely of cash today, how much would I invest in this company?

I return to one simple question:

Is this one of the best places where I can allocate capital today?

Selling Winners Is More Dangerous Than Holding Losers

I would also argue that, for long-term investors, the most damaging side of the disposition effect is selling winners too early.

The whole point of investing is that you are playing a game where the odds are stacked in your favor. Every investment you make can only go to zero, where your winners can grow, compound and keep generating returns for decades. When you sell your winners, you are essentially, destroying your advantage as an investor. You are locking in gains and making the game more symmetrical.

Reducing turnover works not only because it lowers transaction costs and taxes, but also because it preserves this compounding advantage. While cutting losses quickly can sometimes be beneficial, I have come to believe that avoiding the premature sale of great businesses is even more important.

Most fortunes in investing are not built by finding dozens of winners. They are built by allowing a handful of exceptional investments to keep compounding for far longer than feels comfortable.

Experience has helped me reduce the disposition effect, but it hasn’t eliminated it. I still feel the urge to sell winners too early and give losers one more chance. The goal is to try to reduce how this can affect my decisions and become more accurate in accessing prospects. Your purchase price is history. Focus on future returns.