Why Smart Investors Sell at the Worst Possible Time

Many investors think selling is an easy part of investing that doesn’t require a lot of thought. In contrast, buying is exciting. It requires an understanding of valuation numbers, corporate fundamentals, and the macro environment. For many investors, these are interesting challenges that are an enjoyable part of investing. Yet, selling feels to many like an administrative process that’s executed more out of necessity. It’s the dotting of the investment i’s and the crossing of the t’s that concludes the process.

However, in reality, selling is arguably even more important than buying. It’s when human psychology often does the most damage. It’s the moment when gains become real and losses become admissions of mistakes. It’s also the skill that few investors master to their benefit.

Enter the Disposition Effect

With the benefit of hindsight, you may have noticed that your timing when selling funds and stocks could have been better. That’s usually an understatement. And you’re not alone. Even the world’s most experienced investors suffer the same affliction.

There’s a name for the mistake that’s generally at the heart of the selling challenge: the disposition effect.

This is investors’ widespread tendency to sell their winners too early to lock in the upside (read: their pride), and to hold their losers too long in the hope of getting back to even.

This isn’t a niche day trading quirk. It’s how it is for most investors.

It’s also confirmed by research.

Decades ago, research by Hersh Shefrin and Meir Statman framed the disposition effect as a predictable behavioural pattern rather than a series of one-off errors.

Research by Terrance Odean also showed how the disposition effect plays out in the real world. He showed that the proportion of gains realised exceeded the proportion of losses realised: 0.148 versus 0.098. Translation: investors are more likely to sell a stock that’s up than a stock that’s down.

That’s proof there’s a systemic bias toward selling success and holding onto failure.

Why Do Investors Behave Like This?

Why does the disposition effect happen so reliably?

Prospect theory is the main economic explanation.

Kahneman and Tversky argued that people define investment success and failure relative to the reference point of their acquisition price, rather than in portfolio terms. They also showed the value function is steeper for losses than for gains. In simple terms, losses hurt more than the equivalent gains feel good.

So if you find $100 on the street, you’ll feel pleased. But if you lose $100, the pain is noticeably stronger than the pleasure of finding it. Empirically, they estimated that a loss feels roughly twice as powerful as an equivalent gain. This is called loss aversion.

That asymmetry creates two temptations that are disastrous for investors in combination:

- Rushing to Sell Winners

Investors are often compelled to bank their profits, because a gain means concluding the volatile investment journey with certainty and relief.

The problem with this is that winners generally keep winning, so this strategy serves to limit long-term performance.

- Holding onto Losers

Once an investment is loss-making, investors become unusually willing to hold for the longer term because selling crystallises the pain, while holding preserves hope.

The reference point is generally the purchase price. It’s economically irrelevant but psychologically magnetic for investors holding onto losers. If only I could get back to par is the dangerous thought often running through their minds.

But remember: the market doesn’t know or care about your entry price. Your brain’s use of it as a moral ledger of sorts is at best delusional, and more likely detrimental to your long-term investment performance.

You can see why the disposition effect is a big deal for long-term portfolio outcomes.

Mind the Gap

Given how common it is, the disposition effect reveals itself in aggregate market outcomes.

When large numbers of investors act on fear and relief at the same moments, cash flows into and out of funds become pro-cyclical.

To this point, Morningstar’s Mind the Gap research highlighted the glaring gap between funds’ total returns and the return investors actually receive once their contributions and withdrawals are taken into account. Over the ten years to 31st December 2024, the average investor earned 7.0% p.a. while the underlying funds delivered 8.2% p.a.

That sizeable shortfall was mainly attributable to poor investor selling timing. The uncomfortable truth is that most investors sabotage their own investment returns by selling at precisely the moment. Of course, this is generally in direct contradiction to their investment plans which require them to hold for the long term.

How to Avoid the Disposition Effect

So what’s a highly educated investor to do, beyond repeating ‘stay the course’ to themselves whenever the temptation to sell their winners rears its ugly head?

The first step is to treat selling as a process rather than a feeling.

If you can’t pre-commit to some guiding rules during the calm, you’re unlikely to navigate market storms to your benefit. Whether that guide is a professional adviser or a written investment policy statement you actually follow, the mechanism is the same: you’re building friction against impulsive decisions.

Second, separate portfolio decisions from single fund or stock decisions.

A single fund or stock holding invites you to anchor to the purchase price and turn the decision into a referendum on your competence. We’ve all been there.

In contrast, considering the state of your diversified portfolio invites you to think in probabilities and horizons.

So if you’re thinking of selling, make it a portfolio-level act such as rebalancing to a target allocation, rather than a verdict on a single name.

Rebalancing can feel like selling winners, but it’s different in spirit. It’s about maintaining a risk budget, rather than monetising your pride. The key is to stop yourself from turning market movements into identity narratives.

Third, decide in advance which situations genuinely merit a sale.

There are a few defensible categories for investors aiming to sidestep the disposition effect:

• Your time horizon has changed and the asset no longer matches the liability.

• An investment product no longer delivers on fundamental expectations. For example, poor governance, persistent tracking error, style drift, or a structural fee disadvantage relative to substitutes are legitimate reasons for a change of view.

• Your asset allocation is being rebalanced back to your investment plan.

Outside of these, most selling is just a story your brain tells to justify reducing discomfort.

Finally, use the tax system as a selling constraint, rather than an excuse. Remember, the CGT discount makes patience more valuable.

Avoiding the Disposition Effect’s Clutches

If you notice yourself focusing on getting back to even on one or more of your investment losers, treat that as a warning signal that the disposition effect is trying to work its evils on you. Be ready for this. And remember: selling at the wrong time is about being a human sitting in front of a price chart while possessing the ability to trade at any time in any place.

The goal is to take back those voting rights from your emotions. The easiest way to do this is to commit to a few simple selling rules, and automate what can be automated. It’s all about allowing your portfolio the uninterrupted time it requires to work its magic.

Disclaimer: This article is prepared by Simon Turner. It is for educational purposes only. While all reasonable care has been taken by the author in the preparation of this information, the author and InvestmentMarkets (Aust) Pty. Ltd. as publisher take no responsibility for any actions taken based on information contained herein or for any errors or omissions within it. Interested parties should seek independent professional advice prior to acting on any information presented. Please note past performance is not a reliable indicator of future performance.