Disposition Effect
The disposition effect is selling winning investments too quickly while holding losing investments too long, resulting in suboptimal returns and tax inefficiency.
Exam Tip
Disposition effect = sell winners early, hold losers too long. Driven by loss aversion. Tax-inefficient: should harvest losses.
What is the Disposition Effect?
Sell winners too early, hold losers too long. Investors are 1.5x more likely to sell winners.
Tax Inefficiency
- Pay taxes on gains
- Carry unrealized losses
- Should harvest losses instead!
Drivers
- Loss aversion
- Mental accounting
- Pride (selling winners) vs. regret (admitting mistakes)
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Loss Aversion
Loss aversion is a cognitive bias where the psychological pain of losing is approximately twice as powerful as the pleasure of gaining an equivalent amount.
Mental Accounting
Mental accounting is treating money differently based on its source or intended use, violating the principle that money is fungible (interchangeable).
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