Disposition effect

The disposition effect is an anomaly discovered in behavioral finance. It relates to the tendency of investors to sell shares whose price has increased, while keeping assets that have dropped in value.

Description
Investors are less willing to recognize losses (which they would be forced to do if they sold assets which had fallen in value), but are more willing to recognize gains. This is irrational behaviour, as the future performance of equity is unrelated to its purchase price. If anything, investors should be more likely to sell “losers” in order to exploit tax reductions on capital gains. In a study by Terrance Odean, this tax-motivated selling is only observed in December, the final opportunity to claim tax cuts by unloading losing stocks; in other months, the disposition effect is typically observed.

The disposition effect can be partially explained using loss aversion. More comprehensive explanations also use other aspects of prospect theory, such as reflection effect.