I worked in Silicon Valley during the height of the Internet craze and had many friends who were engineers and marketers for high tech companies. Several of them were worth millions from stock options on companies that recently had gone public. They watched the prices go up day after day during late 1999 and early 2000. As prices started to drop in 2000, I asked many of them when they were going to sell their stock. The reply was inevitably something along the lines of the following: “I’ll sell if it gets back up to $X,” a price that was significantly higher than the level at which the market was when I asked. Almost every single one of my friends who was in this position watched the price of his or her stock drop to a tenth or even a hundredth of its previous value without selling the shares. The lower it dropped, the easier it was for them to justify waiting. “Well I’ve already lost $2 million. What’s a few more hundred thousand?” they would say. The disposition effect is the tendency for investors to sell shares whose price is increasing and keep shares that have dropped in value. Some say that this effect is related to the sunk cost effect since both provide evidence of people not wanting to face the reality of a prior decision that has not worked out. Similarly, the tendency to lock in winning trades stems from the desire to avoid losing the winnings. For traders who exhibit this tendency, it becomes very difficult to make up for large losses when winning trades are prematurely cut short of their potential.
