Lesson 2 of 7
Loss aversion and the urge to sell
Investors sell winners early and hold losers long. Replace the purchase price with the thesis as the reference point.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Investors tend to sell winners too early and hold losers too long, a pattern called the disposition effect.
- The pull comes from measuring against the price you paid instead of the reason you bought.
- Replace the price with the thesis: ask whether the reason still holds, not whether the position is up or down.
A stock down 20 percent and a stock up 30 percent get sold for different reasons, and neither reason is usually the business. Loss aversion makes a paper loss feel worse than an equal gain feels good, and that asymmetry shapes which stock leaves the portfolio first.
Two ways to decide on the same holding
Decided against the price paid
- Down 20 percent feels like a loss to accept.
- Up 30 percent feels like a gain to protect.
- The decision resets every time the price moves.
Decided against the thesis
- Down 20 percent, reason intact: the thesis gives no reason to act.
- Up 30 percent, reason broken: the thesis flags it.
- The question is whether the reason you bought is still true.
The price paid measures your entry. The thesis measures the reason.
Why losses hurt more than gains help
Kahneman and Tversky's prospect theory (1979) found that a loss looms larger than a gain of the same size. Later experiments put the ratio at roughly 1.5 to 2.5 (Kahneman, 2011). Applied to a portfolio, that asymmetry pushes an investor to sell a winner to lock in the good feeling and to hold a loser to avoid confirming the bad one.
The pattern has a name
Shefrin and Statman named this the disposition effect: the disposition to sell winners too early and ride losers too long. They traced it to the purchase price acting as the reference point, plus the reluctance to close an account at a loss and admit regret. Odean, studying individual brokerage accounts, found investors realized gains more readily than losses. The losses they held on to went on to underperform the gains they had sold. The habit cost them money.
The reference point is the problem
The purchase price has no claim on what a business is worth today. It only marks where you entered. Fisher, in chapter 6 of Common Stocks and Uncommon Profits, allows three reasons to sell: a mistake in the purchase, or the company no longer meeting its standard. A third, a clearly better opportunity, he says seldom happens. He also named this lesson's habit in 1958: holding on until you can "at least come out even". None of his reasons is the distance from your entry price.
Selling against the thesis instead
The fix is not willpower. It is changing what the decision is measured against. A thesis states the reason you bought and the conditions that must stay true. Selling against the thesis asks one question: is the reason still there. The price you paid is irrelevant. Today's price against your estimate of value is not, and a thesis can carry that as a condition.
Check yourself
In later experiments on prospect theory, a loss was felt about how much more strongly than an equal gain?
- Roughly twice, with estimates from about 1.5 to 2.5
- About ten times as strongly
- About the same
Show the answer
Answer: A.
The 1979 paper established the asymmetry; the ratio came later. Kahneman's 2011 estimates run from about 1.5 to 2.5 times, which is what makes holding a loser feel safer than it is.What did Odean find about the gains and losses individual investors chose to realize?
- They realized losses more readily than gains
- They realized gains more readily than losses, and the losses they kept underperformed
- They realized gains and losses at about the same rate
Show the answer
Answer: B.
Investors sold winners sooner than losers, and the losers they continued to hold went on to do worse than the winners they had sold.This lesson argues a sale decision should stop being measured against one thing in particular. Against what?
- How long you have held the position
- Today's price against your estimate of value
- The price you originally paid
Show the answer
Answer: C.
The purchase price marks only where you entered; it has no claim on what the business is worth today. Price against value is a separate, valid test, covered in the valuation lessons.Sources
- Kahneman and Tversky, 'Prospect Theory: An Analysis of Decision under Risk', Econometrica, 1979, on losses looming larger than gains.
- Kahneman, Thinking, Fast and Slow, 2011, on later estimates of the loss-aversion ratio.
- Shefrin and Statman, 'The Disposition to Sell Winners Too Early and Ride Losers Too Long: Theory and Evidence', Journal of Finance, 1985.
- Odean, 'Are Investors Reluctant to Realize Their Losses?', Journal of Finance, 1998.
- Fisher, Common Stocks and Uncommon Profits, 1958, chapter 6, on the three proper reasons to sell.
What this leaves out
- The disposition effect is a tendency measured across many investors and accounts, not a rule about any single decision.
- Replacing the price with the thesis only helps if the thesis was written honestly before the price moved.
- Price against value is a separate reason to act, covered in the valuation lessons; this lesson removes only the price you paid.
- In a taxable account a realized loss has tax value; Odean found the disposition effect weakened in December, when tax selling peaks.
- Nothing here is advice about any security.