Stock Psychology: The Disposition Effect

By: Shayna Herszage  |  August 31, 2020

By Shayna Herszage, Managing Editor

During summer break, I, like millions of college students, decided to experiment with something risky and strange. However, this risky behavior did not involve substances, fetishes, or crime — rather, I began to venture into the world of investing, specifically the stock market.

One thing I quickly learned about the stock market is that, in fact, I know next to nothing about finance. However, as a psychology major, I can not help but notice that there is an undeniable psychological component to patterns of buying and trading stocks — one that I could use to my advantage. 

The nature of the stock market is similar to that of gambling. A person takes their bets in the form of investment, but they ultimately have no control over the performance of the stock — only educated guesses based off of patterns, news reports, or off of the educated guesses of others.

As such, much of the existing literature about the psychology of gambling also applies to stock investing. For example, a common phenomenon in gambling psychology is the gambler’s fallacy. The gambler’s fallacy dictates that, if an outcome is repeated several times, the likelihood of said outcome occurring again decreases. However, the outcome is not necessarily less likely — hence the fallacy.

Similar to the gambler’s fallacy is the disposition effect — the tendency for stocks to be sold when they are at a high, and the tendency for stocks to not be sold when they are at a low. When a person’s stock is steadily high, they may subscribe, consciously or otherwise, to the notion that their stock may drop at any moment. As a result, they often sell their stocks and quit while they are ahead. Meanwhile, when a person’s stock is steadily low, the opposite occurs. Rather than quitting while they are ahead and selling the stock before it can drop further, people are more likely to hold onto this stock with the expectation that its value may rise at any moment. However, like the case of the gambler’s fallacy, the disposition effect is not necessarily accurate  — the low stock may stagnate or even plunge even lower, and the high stock may stagnate or spike upward. While stocks, by definition, do not exist in a vacuum, they are also not completely dependent on the recently charted data, nor do they strive to defy the patterns.

A study by Frydman et al. provides neuroscientific indication of the power of the disposition effect in stock investment. In the study, research participants traded stocks on a computer while in an fMRI scanner, allowing for observation of neural activity during the stock simulation. The study found that the majority of subjects, when selling stocks at a high price, had increased stimulation of the striatum — a part of the brain, specifically of the basal ganglia, that is instrumental in the reward system. Meanwhile, selling stocks at a low price did not cause the same level of reward system-related activity in the brain. Essentially, these findings showed that the subjects, on a neural level, believed that selling stocks at a high point was inherently more beneficial than selling them at a low point — a belief that is possible, but not inherent. This indicates the presence of the disposition effect in the subjects’ stock trading decisions.

Resisting psychological phenomena is far from easy. By definition, it goes against the way many people are predisposed to perceiving the world around them. However, in the case of trading stocks, a person may benefit from understanding the fallacy of the disposition effect, such that they may overcome the urge to sell high stocks or keep low stocks when they should not. By looking at trends in the world instead of in the vacuum of following the gambler’s fallacy, a stock investor may experience greater profits from their investments.