The Disposition Effect

A person who has not made peace with his losses is likely to accept gambles that would be unacceptable to him otherwise.

(Kahneman and Tversky, 1979) 

Stock brokers prefer to sell stocks that rise in price than stocks that fall in price. The preference for 'winners' over 'losers' is driven only by the desire to realise gains over losses. This is called the disposition effect, and it is likely to lead to lower profits.

This is because attitude to risk is different for losses than gains. Behavioural economics has shown that people tend to be risk seeking when it comes to losses, but risk averse when it comes to gains. For example, a stock that depreciates in value will be seen as a loss, making the stock broker more risk seeking and therefore more likely not to sell it (it may go up in value again). But if the stock rises in value then the stock broker is more risk averse and therefore more likely to sell it (to avoid the risk of it falling in value).

The disposition effect increases taxable income (Odean, 1998). If stock brokers realise 'winners' they have to pay tax on the gain. But stock brokers do not have to pay tax on 'losers'. Thus stock brokers could put off paying tax (and thus earn money) by holding 'winners' for longer. And by selling 'losers' taxable income reduces; if stock brokers sell the 'losers' and buy almost identical stocks taxable income actually falls. Thus the disposition effect is irrational for stock brokers (but good for the Inland Revenue!).

The disposition effect is a violation of fungibility because investors view units of money either side of the gain/loss boundary as qualitatively different. This is an example of non-fungibility causing market failure. If investors were aware of this non-fungibility they might be less likely to exhibit it.