Terrance Odean (1998): The Disposition Effect and Why Investors Hold on to Losing Stocks

Introduction

One of the most common mistakes investors make is surprisingly simple: they sell investments that have made money too quickly and hold on to investments that have lost money for too long. An investor may happily sell a stock after making a 20% profit, locking in the gain, while refusing to sell another stock that has fallen 30% because they are waiting for it to “come back.” This tendency is known as the disposition effect.

The phenomenon was formally associated with behavioral finance through earlier work by Shefrin and Statman, but one of the most influential empirical tests came from Terrance Odean in his 1998 paper, “Are Investors Reluctant to Realize Their Losses?”, published in The Journal of Finance. Odean examined actual trading records from 10,000 individual brokerage accounts and found strong evidence that investors realized gains more readily than losses. Importantly, the behavior could not be fully explained by portfolio rebalancing, trading costs, or the possibility that losing stocks were better future investments. (Wiley Online Library)

The study became an important contribution to behavioral finance because it showed that a psychological tendency observed in experiments could also be found in real-world investment decisions.

What Is the Disposition Effect?

The disposition effect describes an investor's tendency to sell winning investments too soon while continuing to hold losing investments.

Consider a simple example. An investor purchases two stocks. The first rises from ₹100 to ₹130, while the second falls from ₹100 to ₹70. The investor may quickly sell the first stock because they are happy with the ₹30 profit. But instead of accepting the ₹30 loss on the second stock, they may continue holding it, telling themselves that the stock will eventually recover.

The interesting part is that the investor is treating the two investments differently even though the decision should ideally depend on their future prospects, not simply on whether the investment is currently showing a profit or a loss.

If the ₹70 stock has poor future prospects, holding it simply because selling would make the loss “real” may be a poor decision. Similarly, if the ₹130 stock still has excellent growth potential, selling it simply because it has already produced a profit may mean giving up future returns.

This is the central problem that Odean investigated.

Terrance Odean's Research Question

Odean wanted to answer a straightforward but important question:

Do investors actually sell profitable investments more readily than losing investments?

But simply counting the number of profitable stocks sold and the number of losing stocks sold would not be enough.

Imagine a rising stock market. Investors naturally have more profitable stocks in their portfolios because many stocks have increased in value. Even if investors have no psychological preference for selling winners, they might still sell more winners simply because they own more winners.

Odean therefore designed a more careful test. He compared the rate at which investors realized gains and losses relative to the opportunities they had to realize those gains and losses. (Wiley Online Library)

This distinction is extremely important because it allowed the research to examine investor behavior rather than simply looking at the number of winning and losing trades.

The Data: 10,000 Real Brokerage Accounts

One of the strongest features of Odean's research was the use of actual investor trading records.

The study examined 10,000 customer accounts from a large discount brokerage firm. The trading records covered the period from January 1987 through December 1993. The database contained 162,948 trade records, allowing Odean to study how individual investors actually behaved over several years. (Wiley Online Library)

This was significant because much of behavioral finance had traditionally relied on laboratory experiments or hypothetical questions.

Odean was able to look directly at what investors actually did with their money.

The research therefore moved the discussion from:

“Would investors behave this way?”

to:

“Do investors actually behave this way?”

And the answer was yes.

The Main Finding: Investors Realized Gains More Easily Than Losses

Odean found that investors were significantly more likely to realize profitable investments than losing investments. In other words, investors tended to sell winners while continuing to hold losers. (Wiley Online Library)

This is the core evidence for the disposition effect.

The finding is interesting because there is no obvious financial reason why the purchase price of a stock should determine whether it should be sold today.

Suppose an investor bought a stock at ₹100 and it is now worth ₹150. The fact that the investor has made ₹50 should not, by itself, determine whether the stock should be sold.

Similarly, if another stock was purchased for ₹100 and is now worth ₹60, the fact that the investor has lost ₹40 should not automatically mean that the stock should be held.

The correct question should be:

What is the expected future return from holding the stock compared with the alternatives available today?

Yet investors frequently allow their original purchase price to influence their decisions.

That is precisely what makes the disposition effect so interesting.

Why Do Investors Hold Losing Stocks?

One explanation comes from prospect theory, developed by Daniel Kahneman and Amos Tversky.

Prospect theory suggests that people evaluate outcomes relative to a reference point, rather than simply considering their absolute level of wealth. In investing, the purchase price can act as an important reference point.

If an investor buys a stock at ₹100, then ₹100 becomes psychologically important.

A rise from ₹100 to ₹120 feels like a gain.

A fall from ₹100 to ₹80 feels like a loss.

But the psychological experience of the two outcomes is not symmetrical.

According to prospect theory, people tend to be risk-averse when dealing with gains but can become more willing to take risks when facing losses. Odean explains how this framework can help account for investors continuing to hold a declining investment even after its expected return has deteriorated. (Wiley Online Library)

The investor may think:

“I don't want to sell now because then I will have to admit that I lost money.”

Instead, they may continue holding the stock and hope that it eventually returns to their purchase price.

The Psychology of “I Will Sell When It Comes Back”

This is one of the most familiar behaviors in investing.

An investor buys a stock at ₹1,000.

The stock falls to ₹800.

The investor says, “I will wait until it comes back to ₹1,000.”

Then it falls to ₹700.

The investor says, “I cannot sell now. I have already lost so much.”

At ₹600, the investor may become even more reluctant to sell because realizing the loss feels emotionally painful.

The original purchase price has become an anchor.

But the market does not know or care what price the investor paid.

The stock is worth ₹600 because of the information and expectations reflected in its current market price.

The economically relevant question is whether the stock is likely to provide attractive returns from ₹600 onward, not whether it can return to ₹1,000.

This difference between the investor's psychological reference point and the market's current opportunity set is at the heart of the disposition effect.

Why Do Investors Sell Winners Too Quickly?

The other side of the disposition effect is the tendency to sell winning investments too early.

Imagine that an investor buys a stock at ₹100 and it rises to ₹130.

The investor may feel satisfied and decide to lock in the profit.

Selling provides an immediate feeling of success.

But what if the stock later rises to ₹160 or ₹200?

The investor has already exited.

The psychological desire to “book the profit” can therefore cause investors to abandon investments that may continue performing well.

Interestingly, Odean found evidence that the winning investments investors sold subsequently continued to outperform the losing investments they kept. (Wiley Online Library)

This makes the finding especially important.

It suggests that investors were not simply making a harmless psychological choice. Their decision to sell winners and hold losers could actually reduce investment performance.

Could Portfolio Rebalancing Explain the Behavior?

Odean considered several alternative explanations.

One possibility was portfolio rebalancing.

Suppose an investor owns a stock that rises substantially. That stock now represents a larger percentage of the investor's portfolio. Selling some of it could therefore be a rational attempt to restore diversification.

Under this explanation, selling winners would not necessarily represent irrational behavior.

Odean tested this possibility.

The disposition effect remained even after controlling for trading that appeared to be motivated by portfolio rebalancing. (Wiley Online Library)

This strengthened the behavioral interpretation.

The evidence suggested that rebalancing alone could not explain why investors preferred realizing gains over losses.

Could Trading Costs Explain It?

Another possibility was that investors simply did not want to sell losing stocks because losing stocks might have lower prices and therefore higher trading costs.

If a stock's price falls significantly, transaction costs can represent a larger percentage of the value of the position.

Perhaps investors were therefore rationally avoiding the cost of selling cheap stocks.

Again, Odean examined this explanation.

After controlling for share price and related factors, the tendency to sell winners and hold losers remained. (Wiley Online Library)

This meant that trading costs could not adequately explain the observed behavior.

Were Investors Correct to Hold Their Losing Stocks?

This is perhaps the most important question.

What if investors were actually making a rational decision?

Maybe the losing stocks they held were temporarily undervalued and were expected to recover.

If that were true, then holding losers and selling winners might not be irrational at all.

Odean therefore examined what happened after investors sold their winning investments and retained their losing investments.

The evidence did not support the idea that the losing investments were systematically better future investments.

In fact, the winning investments that investors sold continued to outperform the losing investments that they kept. (Wiley Online Library)

This finding is particularly powerful because it suggests that investors were not simply making an informed prediction about future returns.

Their behavior appeared to be associated with poorer subsequent investment outcomes.

The Role of Taxes

There is an interesting exception to the general pattern.

Investors became much more likely to sell losing investments around December.

Why?

Taxes provide a rational reason to realize losses.

By selling a losing investment, an investor can potentially use the realized loss to offset taxable gains, depending on the applicable tax rules.

Odean found evidence of increased tax-motivated selling toward the end of the year, with December standing out in particular. (Wiley Online Library)

This creates an interesting contrast.

During most of the year, investors showed reluctance to realize losses.

But when the tax deadline approached, the financial incentive to realize those losses became stronger.

This suggests that psychological behavior can be influenced by the structure of financial incentives.

The Disposition Effect and Behavioral Finance

Odean's research became important because it provided real-world evidence for a broader idea in behavioral finance: investors are not always perfectly rational decision-makers.

Traditional financial theory generally assumes that investors evaluate investments according to expected returns, risk, and other relevant economic factors.

Behavioral finance asks whether psychological factors can systematically influence those decisions.

The disposition effect is an excellent example.

An investor may know that a stock is performing poorly but still hesitate to sell because doing so would turn an unrealized loss into a realized loss.

The distinction between paper loss and realized loss can therefore influence behavior even though the economic value of the investment has already fallen.

Why “Realizing” a Loss Feels Different

Suppose you bought a stock for ₹100 and it is now worth ₹60.

Whether you sell it or continue holding it, your economic position is already based on the current ₹60 market value.

But psychologically, selling creates a definitive outcome:

“I lost ₹40.”

If you continue holding, you can maintain the possibility:

“Maybe it will recover.”

This difference can be emotionally powerful.

The investor is effectively postponing the moment at which the loss becomes psychologically final.

This is one reason the disposition effect can persist even when holding the stock is no longer the best financial decision.

What the Research Tells Us About Investor Behavior

Odean's findings suggest that investors often behave differently with gains and losses even when the economic situation may call for the same type of decision-making.

A winning investment can create a desire to lock in success.

A losing investment can create a desire to avoid admitting failure.

These emotional reactions can lead to a systematic pattern:

Sell winners → Hold losers → Repeat.

Over time, this can produce a portfolio containing too many investments that investors are reluctant to admit were mistakes.

Meanwhile, investments that were performing well may be sold before their full potential is realized.

The Bigger Lesson for Investors

The disposition effect teaches an important lesson: the price you paid for an investment is psychologically important but economically irrelevant to its future prospects.

If a stock was purchased at ₹500 and is now worth ₹300, the fact that it was once worth ₹500 does not mean it is destined to return to ₹500.

Similarly, if a stock was purchased at ₹500 and is now worth ₹800, the fact that the investor has already made ₹300 does not automatically mean that the stock should be sold.

The better question is:

“Knowing what I know today, would I buy this investment at its current price?”

If the answer is no, holding it simply because you do not want to realize the loss may be an example of the disposition effect.

Why Terrance Odean's Paper Remains Important

Terrance Odean's 1998 study is important because it connected psychological theory with actual financial behavior.

The research did not rely solely on laboratory experiments. It examined thousands of real brokerage accounts and found that individual investors systematically realized gains more readily than losses. The behavior persisted even after considering alternative explanations such as portfolio rebalancing and trading costs. (Wiley Online Library)

Perhaps most importantly, the investments investors sold for gains subsequently performed better than the losing investments they continued to hold. This suggests that the tendency was not merely an emotional quirk—it could have meaningful consequences for investment performance. (Wiley Online Library)

The study therefore became one of the classic pieces of evidence supporting behavioral finance.

Conclusion

Terrance Odean's 1998 research, “Are Investors Reluctant to Realize Their Losses?”, provides one of the clearest demonstrations of the disposition effect in real financial markets. By examining the trading records of 10,000 brokerage accounts from 1987 to 1993, Odean found that investors were more willing to realize gains than losses. (Wiley Online Library)

The behavior could not be adequately explained by portfolio rebalancing, trading costs, or the idea that investors were simply holding losing stocks because they were better investments. In fact, the winning investments investors sold continued to outperform the losing investments they kept. (Wiley Online Library)

The research provides a powerful reminder that investing is not only about numbers and information—it is also about psychology.

An investor may know that a stock is performing badly and still refuse to sell it. Another may sell a successful investment simply because they want to secure a profit. These decisions can feel perfectly natural in the moment, yet they may reduce long-term investment performance.

The disposition effect ultimately teaches a simple but powerful lesson:

Don't confuse the desire to avoid realizing a loss with a rational reason to keep an investment.

The market does not care what price you paid. What matters is what the investment is worth today and what it is likely to be worth tomorrow.

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