On holding losers and selling winners: our emotional brains and the disposition effects

Dr Daniel Richards

For most investors the sensible strategy is to buy a sufficiently diversified portfolio at low fees and hold for the long-term. However, many of us who invest find it hard to resist the temptation to ‘play the market’; buying and selling as we have  hunches about what the market is going to do.  One of the problems with such investment strategies is a common bias that many investors suffer from; the tendency to hold on to investments that are trading at a loss and more quickly sell those trading at a gain. This tendency is often referred to as the ‘disposition effect’.

Have you ever bought a stock, seen the price drop and not done anything?  On the flip side, have you ever bought a stock, seen the price increase and sold too soon?  The good news is that says you are not alone[1], the disposition effect is a common behaviour.  The bad news, this behaviour is associated with poorer performance[2].

Everyone tells you “In stock market trading, cut your losses and let your winners run!”  But this piece of freely given advice is not so easy to implement.   Sometimes there is the little voice in the back of your mind that keeps on saying… “what if” or… “if only” or… “the market is wrong”.  Or perhaps when your investment is trading  at a loss, all of sudden you find plenty of more important things to do other than sell it; such as re-watch TV shows, go shopping, or start Yoga…. again.

Our research investigated the selling of losses and gains by UK stock market investors.  In trying to ascertain who is likely to hold losses and sell gains, we conjectured that emotions play a central role in this behaviour.  We found that those investors who rely on emotions/intuition/gut instinct when making decisions are more inclined to hold losses and sell gains.  However, investors who could reappraise emotions were less inclined to show this bias.  Let’s explain how this occurs.

Emotions and stock market investing?

Let’s take a step back from finance and focus instead on the decision-making.

Since the advent of functional magnetic resonance imaging (FMRI), researchers were given the ability to see what occurs inside our head whilst we perform certain tasks.  It didn’t take long for researchers to get people to make risky decisions whilst in an FMRI machine.  They noticed that parts of the brain that processes emotions, the amygdala and pre-frontal cortex[3], were highly activated when people made decisions about risk.  Furthermore, researchers could not separate when a person was using emotions from when they used cognition; emoting and thinking are intertwined[4].

Stock market investing involves making a lot of decisions under risk.  Thus, emotions are involved when making these decisions and when there is disposition effect.  Researchers identified that when holding a loss the emotion that is involved is regret.  When experiencing a gain, two emotions are involved: rejoicing and elation[5].

Reliance on gut instinct

Most people have intuitive and analytical methods of processing information.  Daniel Kahneman[6] referred to this as System 1 (intuitive) and System 2 (Analytical).

• System 1 is affective (influenced by emotions), fast, and often autonomic
• System 2 is slow, analytical  and deliberative.

Although recent research suggests that these are not, as Kahneman suggests, separate systems, the idea of two separate (although overlapping) thinking processes still seems to have some value. What Kahneman refers to as system 1 makes more use of automatic, process and emotion systems whilst the more effortful system 2 depends crucially on the use of limited working memory in the brain and is hence more effortful and slow. Importantly, people, and therefore investors, vary in how much they rely on System 1 and System 2.  Some investors show a strong faith in following gut instincts, others place a strong weight on analytical decision-making, and others on rely on both or neither.

Our research used a psychometric survey to measure over 280 investors’ reliance on system 1 and system 2 thinking processes.  We then analysed these same investors’ stock market decisions (about 20,000) over a 3 year period to see to what extent the investors held losses and sold gains.

We found that gut instinct matters’ but not in a good way.  Those investors who relied more on the emotional cues (system 1) when making investment decisions were more likely to hold losses and sell gains.  The influence of regret and elation are more pronounced for these investors.

So investors who relied more on analytical decision-making (System 2), sold losses and held gains… right?  Wrong!  We couldn’t find a clear link between analytical decision making and this bias.  The investors who reported a high level of analytical decision making were no more or less prone to the disposition effect.  Saying I only make ‘rational’ decisions does not appear to work.

Regulating your emotions

As well as system 1 and system 2, we also investigated regulation of emotions.  That is, how did investors manage the emotional experience of investing in the stock market?  And did this influence whether they held losses and sold gains?  James Gross[7] has pioneered research on regulation of emotion and has identified two common strategies: reappraisal and expressive suppression.

• Reappraisal:  reinterpreting an emotional situation to reduce its emotional influence.
• Expressive Suppression: inhibit the expressive behaviour of emotional experience (not letting your feelings show).

Research suggests that reappraisal is more effective at reducing emotion, leads to experiencing more positive emotions and can reduce a reluctance to cut losses[8].

In our research we measured the extent to which investors rely on reappraisal and/or expressive suppression when investing in the stock market.   We found that investors who frequently use reappraisal were more likely to sell at a losers and hold on to gains.  However, suppressing emotions showed no relationship to selling losses or gains.

So what?

The take home message from our research can be summarised in 5 points:

• Realise that emotions are integral to investment decision-making – they are part of being human and often very useful.
• Just as we make errors of calculation we can make errors of emotion: Your intuition and gut instinct can create a reluctance to sell losses and/or eagerness to sell gains.
• Forcing yourself to use ignore emotions and apply a reason based approach probably won’t work
• Try to manage the emotions by putting losses or gains in perspective (reappraisal). Think about how this gain or loss relates to your overall investment goals, or your career as an investor.
• Keep a journal. Write down details reasons for buying and reasons for selling a stock.  This will help you improve over a career of investing.

Emotions are prevalent in financial decision-making and regulating emotions is  a learnt skill that takes time to develop.  If you are eager to improve your investing performance, then time should be given to the emotional aspect of investing as well as the number crunching.

A full version of the paper on this research study may be found here:

Richards, D. W., Fenton-O’Creevy, M., Rutterford, J., & Kodwani, D. (2018). Is the disposition effect related to investors’ reliance on System 1 and System 2 processes or their strategy of emotion regulation?. Journal of Economic Psychology. https://doi.org/10.1016/j.joep.2018.01.003

Daniel Richards is a Lecturer at RMIT University in the School of Accounting.  He researches investor decision making and the ins-and-outs of giving finance advice.  His work has been published in the European Journal of Finance and Journal of Economic Psychology.  When not doing research, he teaches financial advice to the new wave of Financial Planners entering the Australian work force.  When not researching or teaching, he is running around after his twins and trying to make palatable home-made beer. 

[1] https://en.wikipedia.org/wiki/Disposition_effect

[2] https://doi.org/10.1093/rfs/hhp060

[3] https://www.ncbi.nlm.nih.gov/pmc/articles/PMC3032808/

[4] https://www.ncbi.nlm.nih.gov/pubmed/16318588

[5] http://dx.doi.org/10.1016/j.obhdp.2012.03.004

[6] https://en.wikipedia.org/wiki/Thinking,_Fast_and_Slow

[7] http://psycnet.apa.org/doi/10.1037/0022-3514.85.2.348

[8] http://www.pnas.org/content/106/13/5035