You will be able to explain the disposition effect and spot it in your own trades.
A few weeks before her review in lesson 2.5, Hui Min needed S$4,000 for the deposit on a wedding venue. She had two SGX holdings worth about that much each. One she'd bought at S$1.00 a share and was now at S$1.40, so her 3,000 shares were worth S$4,200, a gain of S$1,200. The other was the stock from lesson 2.1, bought at S$2.40 and now at S$2.10, with 2,000 shares worth S$4,200 and a loss of S$600. She sold the winner in about ten seconds. Selling the loser never crossed her mind. When she later asked herself why, she couldn't name anything about either company that had guided the choice.
In 1985 the finance professors Hersh Shefrin and Meir Statman gave this pattern a name: the disposition effect, the tendency to sell investments that have gone up too early and to hold investments that have gone down too long. Lesson 1.1 introduced it briefly. This lesson looks at it in your own portfolio.
The pattern shows up in real trading records as well as in experiments. In a well-known study of thousands of accounts at a US discount broker, Terrance Odean found that investors were more likely to sell a stock that was up than one that was down. He also found that the winners people sold tended to go on doing better than the losers they kept. So the habit didn't just feel bad later. On average, it cost money.
Shefrin and Statman explained the pattern using two ideas from earlier in this course.
The first is loss aversion, from lesson 2.2. Selling a loser makes the loss final, and that moment hurts. Holding keeps alive the hope of getting back to even. Selling a winner does the opposite: it locks in a gain and delivers a small, pleasant feeling of having been right.
The second is mental accounting, from lesson 3.1. Instead of seeing one portfolio, people treat each holding as its own account with its own score. The winner's account is in profit, so it can be closed happily. The loser's account is in the red, and closing it means writing down a loss next to your name.
They also pointed to regret, the wish to avoid admitting a mistake. Other researchers have offered further explanations, such as a belief that prices which have fallen will bounce back. The cause is still argued over. The behaviour itself is well documented.
Lesson 2.1 made the central point: the price you paid is your reference point and no one else's. Hui Min's S$2.40 matters a great deal to her and not at all to the market. The company's future profits, its debts and its competitors are what will move the price from here. None of them are affected by her purchase price.
This also means "getting back to even" is not a goal the investment can help with. If the shares go from S$2.10 back to S$2.40, she'll be glad. But the question of whether to hold them is exactly the same question as whether to buy S$4,200 of them today. Every day you hold a stock, you are in effect choosing to buy it again at the current price.
The disposition effect also tilts a portfolio over time. If you keep selling what's working and keeping what isn't, your holdings gradually fill with your worst ideas. That's the opposite of what most investors intend, and it can happen without any single decision feeling wrong.
The practical test is the one from lesson 2.4, applied to every holding: if I had this money in cash today, would I buy this investment, in this amount?
For a holding showing a gain, a yes means selling would only be about locking in a good feeling. For a holding showing a loss, a no means the purchase price is the only thing keeping you in.
Hui Min applied the test after the fact. For the winner, she'd have bought it again at S$1.40; the company's prospects looked as good as when she first bought. For the loser, she wouldn't have bought S$4,200 of it today. If she'd used the test before raising the S$4,000, she'd have sold the loser instead and kept the winner. It wouldn't have guaranteed a better result, because the loser might have recovered. It would have been a decision about the companies rather than about her feelings towards S$1.00 and S$2.40.
There's one caution. The test doesn't mean you should sell every loser. Some fall for reasons that pass, and are still good holdings. And for a broad index fund held as part of a plan, a fall is usually a reason to stick to your rules, as Build and run an ETF portfolio covers in its module on rebalancing. It is a way to take the purchase price out of the decision, and it never tells you on its own to sell.
Go through what you hold today and sort it into holdings showing a gain and holdings showing a loss, and ask of each one whether you'd buy it today.
List your holdings showing a gain and a loss and write whether you would buy each one today.
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