“The mind is not designed to grasp the laws of probability, even though the laws rule the universe.”
 Steven PinkerHow the Mind Works

I think most of us know that, when tossing a coin, no matter how many times in a row the coin lands heads up, the odds of the next toss of the coin resulting in it landing as heads remains 50 per-cent.  Even if it lands heads up four times in a row, the chance of the next toss landing heads up does not alter.

However, as Richard Restak explains in his book ‘Mozart’s Brain & the Fighter Pilot’, when it comes to predicting whether the next toss will land heads or tails up you are more likely to make the correct call if you don’t know that the four previous times it landed heads up.  Regardless of the logic, if you see a pattern of consecutive heads your instinct will tell you that it’s time for a change and you are more likely to call tails.

This kind of instinctive behaviour is often displayed by investors.  It’s even got a name – the ‘disposition effect’.  It also affects people’s ability to act rationally when deciding whether or not to sell a stock they hold in their portfolio.  Investors holding a stock showing a loss will often display huge reluctance to sell it, regardless of the fact that there may be compelling reasons to do so.  As with the run of heads when tossing a coin, investors can convince themselves that a declining stock price must experience a turning point at some stage.

The problem is that the stock – like the coin- has no knowledge of its previous share price.  It may be that the price will rebound but that will have nothing to do with the price the investor paid for the stock.  How much you paid for something does not determine whether or not it will turn out to have been a good investment.

Investors will sometimes go to great lengths to avoid selling and realising a loss.  As long as they continue to hold it they can tell themselves that one day it will recover, justifying their original decision to purchase the stock.  Once they sell it however, they can no longer avoid the fact that they lost money.  Academic research has shown that we are twice as sensitive to losses as we are to gains.  No one likes to admit they were wrong.

How can we overcome the disposition effect?  The first step is to understand human behaviour and the fact that because you are hard-wired to want to avoid losses this might compromise your ability to be objective.  The second may well be to work with someone who can help be that voice of reason when you need it.

Warm regards