The disposition effect is a cognitive bias in behavioral finance that describes the tendency of investors to sell assets that have gained value while holding onto assets that have lost value. This behavior stems from the greater emotional impact of losses compared to gains, leading investors to realize profits too early and cling to losing investments in hopes of breaking even.
An example of the disposition effect is when an investor sells shares of a company that has risen in value by 20% but refuses to sell shares of another company that has fallen by 30%, believing the latter will eventually recover.
To overcome the disposition effect, investors can practice hedonic framing, which involves viewing gains and losses in terms of smaller increments rather than as one large event, making it easier to take a rational approach to investment decisions.