By this point in our little exploration of your inner mind, you might be getting a little upset. After all, we’ve seen that you (or at least, your unconscious mind) base decisions on money that’s already gone, overestimate how quickly statistical deviations will be corrected, and over-discount future money; with all of that to contend with, how much more can your brain possibly mess up your financial plans? Well…
You know that relative who saves just about everything, keeping not only the normal mementos of friends and family (things like old report cards and artwork from children), but hangs on to everything, no matter how useless it seems to everyone else? That’s the disposition effect at work; the nature of people to hold onto something rather selling and acknowledging how little it is actually worth. Regardless of how likely it is that we will ever use a particular item again, our minds are more at ease if we hold onto it forever, just in case.
It’s the same with investments; people have a tendency to hold onto investments that have fallen in price, regardless of how unlikely it is that they will ever recover in value, rather than selling and acknowledging the loss. Of course, the inverse is true, and can be just as damaging: we’re more eager to sell when our investments are up, regardless of how much further up they might go. Combine the two effects, and you have the recipe for sub-par investment results regardless of how the market actually performs.
Disposition Effect Examples
-The pile/filing cabinet/room that many people have, filled with instruction manuals for objects that have long since been replaced, tax returns spanning the last several decades, and every receipt we’ve ever received. If we were really honest (and yes, I’m as bad as anyone about this), we’d come right out and admit that we could throw most of this stuff out and never even know it was gone, but part of our mind finds comfort in knowing that it is there.
-Self-Storage places, where you can pay by the month to stow some of your excess stuff. The entire business model is designed on the assumption that you are willing to pay each month so that you can get stuff out of your house, but still want to be able to retrieve it at any time. The convenience is almost certainly not worth the expense.
-As mentioned before, the willingness of investors to hold onto their losers and cut their winners short is also an example of the disposition effect at work. While doing so may make you feel better (you can crow about the stocks you had that shot up while pretending the ones that declined can still increase), you’re doing the exact opposite of what you should be, investment-wise; holding the stocks that rise and getting rid of those that fall.
Beating the Disposition Effect
Beating the disposition effect is basically an issue of mind over matter. You should know, in the rational part of your mind, that the chance of benefiting by holding onto many of your possessions is very low; unless your attic is filled with rare artwork or your basement holds pristine baseball cards from the thirties, most of your stuff is only as valuable as the use you can get out of it. If you aren’t using it, particularly if it’s just taking up space in your house, dorm room, or apartment, you’ll likely be better off selling it for money with which you can purchase something you WILL use. (Or better yet, why not invest the sales proceeds so you’ll have more money in the future?)
The simplest solution is to go through your possessions on a regular basis, figure out which you need and don’t need, and get rid of what you don’t need (selling it, throwing it away, trading it with someone else, whatever strikes your fancy, as long as it gets the item out of your living area). If you’re a pack rat like me, it’s going to be tough, but it’ll be worth it to make your living space more, well, livable.
I’m not going to try to set out a precise definition of what exactly falls into the category of ‘needed’; you are going to have to give some thought as to what you consider necessary and unnecessary in your life and work from there. For me, I would include regular use items (like my clothes and computer), seasonal items (holiday decorations and the like), mementos (things like report cards or art work I did as a child), and collectibles (so I have a category for my manga, really) as my ‘needed’ items, and everything else would be fair game to sell or trash, from books I haven’t read in years (which have no emotional value attached) to most of the DVDs I’ve accumulated in the past.
For investments, that same type of discipline will pay off. Know when you make the initial purchase how you’re going to respond if the price goes down (Sell it when it drops a certain percentage? Buy more when it dips lower?) and if the price goes up (Sell it when it gains a certain amount? Wait to see how high it goes, selling when it starts to dip from its peak?). Even the best laid investment plan won’t always increase in value, but if you make a plan for what to do in any event (and more importantly, you STICK to your plan), you’ll be much better in the long run.