Why You Sell Your Winners Too Early

There is a well-documented tendency among individual investors to sell positions that have appreciated and hold positions that have declined. The pattern is consistent across markets, time periods and levels of sophistication. It has a name — the disposition effect — and it is expensive.

Why it happens

Realising a gain feels like being right. Realising a loss feels like admitting a mistake. Since the paper position is unrealised, it remains, psychologically, not yet a mistake. The result is a portfolio that systematically sheds its best holdings and accumulates its worst.

The effect is amplified by anchoring to purchase price, which is a number with no economic significance whatsoever. What you paid for a security tells you nothing about what it is worth today.

The structural fix

Behavioural problems are rarely solved by resolving to behave better. They are solved by changing the decision structure so the behaviour is not required.

The most effective structural fix we have found is writing the exit condition at the point of entry, in terms of the business rather than the price. "Sell if the margin thesis fails" is a checkable condition. "Sell when it is up 30%" is anchoring wearing a rule's clothing.

Practical steps

• Write the exit condition before you buy, phrased in business terms.
• Review holdings against their thesis on a schedule, not when the price moves.
• Hide your purchase price from your working view of the portfolio if you can.
• Ask of every holding: would I buy this today at this price? If not, why hold it?

The last question is the most useful and the most uncomfortable, which is generally a good sign.