Disposition Effect

Disposition Effect is tendency of investors to sell their winners too early in order to lock in gains, while holding on to losers too long in the hope of making back what they have lost.

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This effect is due to mental accounting (paper loss is less painful than a realized loss), regret aversion (worrying aoubt doing the wrong thing), lack of self control (abandoning rules you set for yourself) and tax issues.

The disposition effect leads to underreaction to news events among mutual fund managers. Asset prices do not immediately rise to their fair value when good news occur due to premature selling. Moreover, on bad news prices fall less than tey should because institutional investors are reluctant to sell.

Both of these actions delay the price discovery process, which contributes to the momentum effect as stocks continue trending toward their fundamental value.