The disposition effect is when investors sell winners too early and hang onto loser for too long[2]. This is a manifestation of the Allais paradox[1], which showed an inconsistency between the theory of expected utility and the sub-optimal and often irrational choices that individuals make. Its foundations are built upon several theories. One such is prospect theory, where investors fear losses more than they cherish gains, hence individuals would delay the realisation of losses. Another is seeking pride and avoiding regret, where a realisation of the loss would be proof that their judgement was flawed and not taking the loss would avoid regret.
This can be seen in the behaviour of investors, where they are twice as likely to sell a winning stock than a losing stock[3]. The average investor would have a greater ratio of average unrealised losses than the average ratio of realised gains.
Using traders as an example, the first cohort of traders who don’t survive are those who cannot realise their losses quickly and/or hang onto their gains. They lack discipline and are plagued with the disposition effect.
[1] Allais, Maurice (1979). Allais, Maurice; Hagen, Ole (eds.). Expected Utility Hypotheses and the Allais Paradox. D. Reidel Publishing Company. doi:10.1007/978-94-015-7629-1. ISBN 978-90-481-8354-8.
[2] Shefrin, H. and Statman, M. (1985) ‘The Disposition to Sell Winners Too Early and Ride Losers Too Long: Theory and Evidence’, Journal of Finance (Wiley-Blackwell), 40(3), pp. 777–790. doi:10.1111/j.1540-6261.1985.tb05002.x.
[3] Barber, B.M. et al. (2007) ‘Is the Aggregate Investor Reluctant to Realise Losses? Evidence from Taiwan’, European Financial Management, 13(3), pp. 423–447. doi:10.1111/j.1468-036X.2007.00367.x