What Is The Disposition Effect And How To Avoid It
Decision making, especially financial decision making requires a lot of mental energy to be effective. Which is why the brain often relies on heuristics. The catch is, this can, and often does, lead to biased behaviour. The disposition effect is an example of recognised, common biased behaviour.
What is the disposition effect
The disposition effect relates closely to loss aversion (phenomenon where we hate losing more than we like winning).
The effect is that we keep pouring our time, energy and money into something that is not performing optimally, in the hopes of it turning around and us being able recover our losses.
If we have to choose, we rather get rid of something that has already done well, thus eliminating the possibility of continuing to benefit from it, than something that we have invested time/effort/money in and it hasn’t paid off.
The disposition effect has been mainly studied in investing context, but can be applied to other things as well.
For example, we might struggle to leave a relationship that is no longer working (or that is toxic) in the hopes that something will change, rather than cutting our losses.
How to avoid it
As always with heuristics and biased behaviour, being aware of the possibility of being biased is the first step to avoiding it, and disposition effect is no different.
Knowing, and really internalising that we can’t always win and it is okay to cut your losses (and sometimes that is the best option!), can help too when it is time to make decisions.
Reminding yourself of the bigger picture can help too.
For example, if you look at your investment portfolio as a whole, you can see which investment is consistently dragging the performance of the portfolio down. This viewpoint might make it easier to make a logical decision.
This works with the relationship example as well. If you look at your life as whole and how the relationship fits into how you want your life to be, it might make it easier to break off something that isn’t serving you any more.
Remember: we win some and we lose some. That’s just life and it’s okay to change your mind after a bad decision.
Disposition effect in personal finance
As mentioned above, the disposition effect has been mainly studied in relation to investing decisions, so the effects of it are well known.
On an individual level, this effect leads to hanging on to bad investment decisions for longer than it rationally makes sense, jeopardising the financial results.
This can also lead to higher tax obligations by realising (possibly unnecessary) capital gains (instead of losses) which will be a further financial cost of the effect.
And as mentioned above, it is important to look at the portfolio as a whole when making buy, or sell decisions. This will help you avoid the disposition effect.
On a bigger scale, this effect can really affect the performance of managed funds.
In fact, a study was done into managed funds and it found that those funds that were prone to disposition effect were falling behind by 4-6%/year compared to funds which were not prone to this effect!
The study also found that these funds that were prone to the effect were less likely to survive after 5 years (77% compared to 85% of not prone funds).
This means that choosing to invest in a managed fund that suffers from the effect can really affect your investment gains. Unfortunately information like this is usually not very apparent as you are making an investment decision.
You can read more about the disposition effect here. And this will take you to the list of other heuristics and biases I have covered here on the blog.
Have you made a decision based on the disposition effect? Share in the comments!
