Disposition Effect & Tax-Loss Selling
The Disposition Effect
Definition: Tendency to sell winners too early and hold losers too long.
Discovery: Terrance Odean (1998) analyzing 10,000 brokerage accounts found:
- Winners sold 50-70% more readily than losers
- Cost: ~2-4% annual underperformance
Behavioral Explanation
Loss Aversion: Realized losses hurt more than unrealized—avoid pain by holding
Reference Dependence: Purchase price = reference point; won't sell below it
Prospect Theory: Value function is concave for gains (risk-averse after gain), convex for losses (risk-seeking to avoid loss)
Mental Accounting: Closing winning position feels good; realizing loss feels like admitting failure
Market Consequences
Momentum: Winners under-owned (sold too early) → Continue rising
Value: Losers over-owned (held too long) → Become undervalued bargains
Tax Inefficiency: Paying capital gains on winners, missing tax-loss harvesting
Portfolio Drag: Dead money tied up in losers
Tax-Loss Selling
Rational Strategy: Sell losers in December to offset capital gains for tax savings
Reality: Most investors don't do it (disposition effect override)
January Effect: Oversold losers in December (tax-loss selling) bounce back in January
Indian Context: Less pronounced (no short-term vs long-term capital gains differential like US until recently)
Overcoming Disposition Effect
Rules: "Sell any position down >20% automatically"
Regular Rebalancing: Forces selling winners, buying losers systematically
Mental Accounting Fix: Ask "Would I buy this stock today at current price?" If no, sell.
Track Total Portfolio: Not individual positions—reduces attachment
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