Loss Aversion and the Disposition Effect: Why We Cut Winners and Hold Losers

What you will learn

• The core ideas of prospect theory: reference point, loss aversion and diminishing sensitivity.
• What the disposition effect is and why it damages a trading result.
• How to measure your own disposition effect with two simple ratios.
• Rules that reduce the effect without relying on willpower.

Explanation

Prospect theory

Prospect theory, developed by the psychologists Daniel Kahneman and Amos Tversky in 1979, describes how people actually choose under risk. Three ideas matter for traders:

• Reference point: we judge results as gains or losses relative to a starting point, usually the entry price, not by total wealth.
• Loss aversion: a loss feels stronger than a gain of the same size. In their experiments, losses were weighted roughly twice as heavily as equal gains; the exact factor varies between people and situations.
• Diminishing sensitivity: the difference between €0 and €100 feels bigger than between €1,000 and €1,100. This makes people risk-averse in gains (take the sure profit) and risk-seeking in losses (gamble to avoid making the loss real).

The disposition effect

The disposition effect is the tendency to sell winning positions too early and to hold losing positions too long. The term was introduced by Hersh Shefrin and Meir Statman in 1985. It follows directly from prospect theory: a small profit invites you to "lock it in", while closing a loss turns a "paper loss" into a real one, which hurts. Related is the sunk cost fallacy: continuing because of money already lost, although past costs cannot be recovered by waiting.

Why it matters in numbers

In the R-multiples lesson of the risk management course you learned that expectancy depends on win rate and average win versus average loss. The disposition effect attacks exactly the second part: it shrinks average wins and enlarges average losses. A high win rate can then hide a negative system.

Measuring it: PGR and PLR

The finance researcher Terrance Odean used two ratios to measure the effect in brokerage accounts. You can apply them to your own journal. Each time you sell or close something, look at every position you could have closed at that moment:

• PGR (Proportion of Gains Realised) = realised gains ÷ (realised gains + paper gains).
• PLR (Proportion of Losses Realised) = realised losses ÷ (realised losses + paper losses).

A paper gain or paper loss is an open position that is currently in profit or loss but was not closed. If PGR is clearly larger than PLR, you realise gains more readily than losses: a sign of the disposition effect.

Worked example

Hypothetical example 1 (expectancy): a trader wins 60% of trades. Because he takes profits early, his average win is €80. Because he holds losers, his average loss is €160. Fees, spreads and taxes are excluded.

• Expected result per trade = 0.60 × €80 − 0.40 × €160
• = €48 − €64 = −€16 per trade

Despite winning six trades out of ten, he loses on average €16 per trade.

Hypothetical example 2 (PGR and PLR): over one quarter, the same trader made several closing decisions. Counting across all those decision days: 6 realised gains and 14 paper gains; 2 realised losses and 18 paper losses.

• PGR = 6 ÷ (6 + 14) = 6 ÷ 20 = 0.30
• PLR = 2 ÷ (2 + 18) = 2 ÷ 20 = 0.10

He realised gains three times as readily as losses (0.30 ÷ 0.10 = 3). Combined with example 1, the diagnosis is clear: the problem is not the entries but the exits.

Rules that help

• Define stop and target before entry and place the stop order in the market immediately.
• Allow the stop to move only in the direction that reduces risk, never further away.
• Ask the "fresh entry" question: "If I had no position, would I open this trade now at this price?" If not, the reason to hold is the reference point, not the chart.
• Review exits monthly: compare average win and average loss in R.

Common mistake

Practice activity

On paper, use these hypothetical numbers from a journal: 9 realised gains, 6 paper gains, 3 realised losses, 12 paper losses. Calculate PGR and PLR and decide whether the disposition effect is visible.

Key takeaways

• Losses feel stronger than equal gains, and the entry price acts as an emotional reference point.
• The disposition effect shrinks average wins and enlarges average losses, which can make a high win rate unprofitable.
• PGR and PLR turn the effect into numbers you can track.
• Fixed stops, the "fresh entry" question and regular exit reviews reduce the effect.

Next step

The next lesson covers four more biases that distort how you collect and judge information: confirmation, recency, anchoring and hindsight.