Avoiding Cognitive Biases: The Disposition Effect

by | Dec 24, 2014 | Podcasts, Investor Behavior

On this week’s Mullooly Asset Management podcast, Tom and Brendan discuss a cognitive bias known as the disposition effect. Cognitive biases such as the disposition effect, loss aversion, confirmation bias, and others can negatively affect investment performance. Tom and Brendan specifically address the disposition effect and how our rules based approach at Mullooly Asset Management helps us to avoid irrational and emotional investing.

Hersh Shefrin and Meir Statman wrote about the disposition effect for The Journal of Finance in 1985. They define the disposition effect in their article titled The Disposition to Sell Winners Too Early and Ride Losers Too Long stating:

“Investors are more likely to sell a stock that has gone up in value than one that has gone down in value.”

In terms of decision making, this is obviously questionable behavior driven by the human tendency to avoid loss. Another area where this behavior is suspect pertains to taxes. Selling a stock that’s gone up means paying taxes on your gains, while selling a stock that’s gone down can mean lowering your capital gains tax at the year’s end. Tax efficiency is an important aspect of investing, so this should definitely be considered.

Wesley Gray, Ph.D. of Alpha Architect gave an easy to follow example of the disposition effect in action that we’ve paraphrased below:

Hypothetically, you bought two stocks for $50 each. Since purchase, one of them has risen to $60 and the other has fallen to $40. Life throws you a curveball and you need to take some money out of your account. Which position will you sell to raise the necessary cash?

Research has shown that people are more likely to sell the $60 stock and realize the gain associated with it than they are to sell the $40 stock and realize the loss associated with that.

Let’s simplify this even further: what do you associate taking a loss on a stock with? Probably losing, right? Nobody likes to lose. Referring to the example above, generally the correct decision would be to sell the loser, take the loss, and let the winner run. Not only are you sticking with the more successful investment, but you’re being more tax efficient as well. Not many investors are willing to accept “defeat” in a stock though. They’d rather take the “victory” and cash in their gain, while hoping the loser can right the ship. In most instances, this is wishful (and dangerous) thinking.

Cognitive biases get in the way of rational decision making all the time. So how do we combat them at Mullooly Asset Management?

Point and figure helps us avoid cognitive biases and irrational decisions. Having a rules based investment approach is a great way to take emotion out of the picture. These charts clearly display what’s happening right now with our investments. As we frequently say: when the charts change, we will change.




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