The study, Disposed to Be Overconfident, examines the disposition effect. This is the well-known tendency for investors to sell shares that have increased in value too soon, while keeping losing investments for too long. The researchers argue that this behaviour can distort how investors judge their own ability. The study was recently accepted in the prestigious Journal of Finance.

Most individual investors do not use complex calculations to judge how well they are doing. Instead, they may focus on a simple question: how many investments did I sell at a profit, compared with how many did I sell at a loss? This offers an easy way to remember success. But it leaves out investments that have risen or fallen in value without being sold.

The authors studied survey responses and transaction records from 1,479 clients of a Dutch financial institution. They found that investors who had sold more investments at a profit than at a loss rated their own investment performance more highly. This relationship remained even when the researchers considered the overall return on investors’ portfolios. Investors also tended to remember more profitable sales than they had actually made.

The researchers then tested this explanation in controlled experiments in the United States. Participants made investment decisions while a computer automatically sold either winning or losing shares. The 2 groups received similar information about their overall investments and achieved comparable results. Yet participants whose winning shares had been sold were more confident that they would outperform other investors.

This confidence affected their behaviour. In a second experiment, participants who had experienced more profitable sales invested more heavily in risky shares. On average, they chose more risky investments than would produce the best likely financial outcome under the conditions of the experiment.

A third experiment showed that this effect remained when participants knew in advance how the computer would decide which shares to sell. This suggests that investors did not see sold winners as a hidden signal about the quality of their choices. Instead, the act of selling at a profit itself influenced their beliefs.

The findings show how 2 common errors in financial decision-making can reinforce each other. Selling winners and holding on to losers may not only affect investment returns. It may also lead investors to believe that they are more skilled than they really are. This can encourage them to take excessive risks.