CFA Level IPortfolio ManagementMedium
An investor holds a stock that has declined 40% since purchase and refuses to sell it, stating 'I'll sell once it gets back to what I paid for it.' Meanwhile, she quickly sold another stock after it rose just 10%, fearing it might give back the gain. This pattern of behavior is best explained by:
- AHindsight bias
- BThe disposition effect driven by loss aversion
- CRepresentativeness bias
- DConfirmation bias
Show answer & explanationAnswer & explanation
Correct answer: B. The disposition effect driven by loss aversion
The disposition effect describes the tendency to hold losing investments too long (hoping to break even) while selling winning investments too soon, driven by loss aversion—the asymmetric pain of losses relative to the pleasure of equivalent gains.
Why the other options are wrong
- A. Hindsight bias involves believing past events were predictable after the fact, not holding/selling behavior.
- C. Representativeness bias involves judging probabilities based on similarity to a stereotype, unrelated here.
- D. Confirmation bias involves seeking information that confirms existing beliefs, not holding/selling patterns.
Disposition Effect
A behavioral tendency to sell winning investments too early and hold losing investments too long, driven by loss aversion and reference-point (purchase price) anchoring.
- Rooted in prospect theory's loss aversion concept
- Can lead to poor tax efficiency and suboptimal portfolio composition
- Investors treat break-even point as a psychological anchor
Memory trick: Sell the winners fast, hug the losers too long