Disposition Effect in Behavioral Finance

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What is Behavioral Finance?

Behavioural finance is a field in behavioural economics that deals with psychological influences and biases. It also examines how these biases impact financial behaviours that investors demonstrate. Furthermore, it studies how these behaviours affect the financial markets, such as the stock market. Behavioural finance also explains how influences and biases cause market anomalies in financial markets.

Behavioural finance also comes in the form of a theory that infers investors are “normal”. By stating that, it goes against some other traditional economic theories. Among other things, it also suggests that investors let biases affect their decisions. These biases may come from various sources. One of these includes the disposition effect.

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What is the Disposition Effect in Behavioral Finance?

The term disposition effect refers to the bias that individuals have in prematurely selling assets that have made financial gains. This effect relates to flawed decisions made by individuals. The disposition effect primarily affects financial markets and investors. In that regard, it describes how investors sell securities as soon as the price rises. By doing so, they sacrifice any potential gains that they would get from holding it longer.

The disposition effect seeks to explain the rationale behind how investors tend to treat unrealized gains and losses on their assets. More specifically, it suggests that investors are likely to realize gains quickly to lock them. However, they tend to hold to loss-making assets longer, hoping it would turn profitable in the future. In both these cases, the disposition effect causes losses for investors.

How does the Disposition Effect work?

How the disposition effect works can best be explained and understood through an example. An investor wants to free up some funds to invest in a potential high-return asset. However, they don’t have the funds necessary to do so. Instead, they must sell one of the two stocks that they are holding. Both of these stocks are of the same value but have different features.

When the investor bought the first stock, they expected to make significant returns in a few years. Until now, the investment has only increased slightly in value. On the other hand, the investor also bought the second stock with a similar view. However, it has suffered considerable losses since the investor acquired it.

Logically, the investor would want to get rid of the loss-making stock because it can potentially amplify the losses. Similarly, they would prefer to hold onto the first stock as it can potentially increase returns. Due to the disposition effect, however, the investor chooses to dispose of the first stock. The first reason why they do so is to lock the current returns from it. On top of that, they hold onto the second stock, hoping it would turn around and be profitable.

How to avoid the Disposition Effect?

The best way to avoid the disposition effect is to dispose of loss-making investments in the long run. It does not suggest that investors should dispose of their assets as soon as they make a loss. However, they shouldn’t stick to any investments that have suffered from losses continuously. On top of that, investors must not get rid of assets as soon as they become profitable. By doing so, they can avoid any losses and increase their gains.

Conclusion

The disposition effect in behavioural finance refers to the bias that individuals demonstrate when making decisions. This effect is relevant to the financial market and investors. When investors sell profit-making assets prematurely or hold onto loss-making assets, the disposition effect comes into play. Investors can easily avoid the disposition effect by avoiding both of these circumstances.

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