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Beginner · Lesson 1 of 4Loss aversion and the disposition effect
Daniel Kahneman and Amos Tversky's prospect theory (1979) found that losses feel about twice as painful as equal gains feel good. This leads to the disposition effect: selling winners too early to lock in the good feeling, and holding losers too long to avoid admitting a loss.
A useful test: "If I had cash today instead of this share, would I buy it at this price?" If not, the purchase price is irrelevant; it is a sunk cost.
Pre-commit to rules (stop levels, review dates, target weights) while you are calm, and write them in the Vestora Journal.
Key takeaways
- Losses hurt about twice as much as gains please.
- Investors tend to sell winners and keep losers.
- Ask: would I buy it today at this price?
Check your understanding
1. The disposition effect is the tendency to...
- Buy index funds
- Sell winners early and hold losers too long
- Diversify too much
- Ignore dividends
Show the answer
Sell winners early and hold losers too long. Driven by loss aversion.
2. Your purchase price for a share is best thought of as...
- The fair value
- A sunk cost for decision-making
- A guaranteed floor
- The analyst target
Show the answer
A sunk cost for decision-making. The market does not know or care what you paid.
Go deeper
- Wikipedia: Loss aversion
- YouTube videos: loss aversion disposition effect investing
- Investopedia: disposition effect
- Wikipedia: Prospect theory
- Wikipedia: Disposition effect
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