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How Thinking
Affects Investing

Disposition Effect

A second cognitive bias caused by loss aversion is the DISPOSITION EFFECT: the tendency to wait too long to take losses or to move too quickly to realize gains.

Because most of us tend to be loss averse, we will often hold onto a stock that has decreased in value long past the time when it would have made sense to sell. By hanging onto the stock and hoping it will go back up, we are able to avoid the regret that comes from acknowledging that the loss is permanent.

Conversely, when we are fortunate enough to have one of our stocks go up quickly, loss aversion will often induce us to sell the stock too soon. Why? Because selling a stock that has gone up in value — even when it makes sense to keep holding it — locks in our gain, which is one way to deal with the fear that a sudden drop in price will turn a winner into a loser

Over the long term, the disposition effect is responsible for a great deal of lost profit: instead of buying and selling rationally, we end up holding on to losers and selling our winners.

A more rational strategy is to perform a regular assessment, during which we set aside our feelings and take a frank look at our investment portfolio. At that time, we can evaluate each stock and — regardless of the history of the stock's price — ask the question: Right now, is this stock worth owning?

This allows us to identify the stocks we should not own any longer, so we can sell them and invest the money in holdings with more growth potential. Because of the disposition effect, however, making such impersonal decisions can be difficult.

If you study investors who have long-term success, you will see that they have learned how to overcome the disposition effect. This enables them to jettison losers as quickly as possible, and keep winners long enough to develop to their full potential.

To make it easier for yourself, when the time comes to evaluate your holdings, I suggest that you remember the following principle.

Harley's Rule of Investing #5

Ignore what you feel.
Buy and sell when it makes sense to do so.

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