Why we get it wrong (disposition effect and prospect theory)
One unprofitable tendency that all inexperienced investors have is to sell winning investments too early and to ride losing investments for too long. Many never overcome this poor investment behaviour. In learning to become good investors we have to work at reversing this very natural behaviour pattern.
This problem is not restricted to investing. Researchers first began to understand it through the study of gambling. This research led to the more general study of why people tend to make irrational decisions in many common situations that involve choices in the face of uncertainty. This has been of immense importance in economics, where theoretical models had assumed that people would always make rational choices.
One important area of research has been into what has been called the disposition effect, named by Hersh Shefrin and Meir Statman from the observation by Gary Schlarbaum, Wilbur Lewellen and Ronald Lease, who first described the disposition to sell winning investments and ride losing investments.
What the researchers had verified from statistical studies of stock market investors had already been well established in the folklore of the markets. Ever since there had been a stock market, investors had lamented that their poor results had come from too many small profits and too many large losses. ...