When one of my investments loses money, I feel bad. But what I do about it depends on who I can blame.

Investors are reluctant to feel the pain of regret and thus tend to be reluctant to sell their loser investment positions. We are much quicker to sell our winner positions and feel pride. This is known as the disposition effect. Scholars have discovered that the disposition effect is pervasive and has been found in the ownership of stocks, real estate, options, and futures. This behavior has been found for US investors and investors in Finland, Israel, and China (I published this research). But it does not occur for owning mutual funds. Why?

Three financial scholars illustrate that the answer involves resolving cognitive dissonance. Cognitive dissonance occurs when two of our thoughts conflict. This causes us discomfort that we need to resolve. Our mental tools to resolve cognitive dissonance are:

  1. Change one or both thoughts so they agree.

  2. Change the importance of one of the thoughts.

  3. Add a third thought that makes it better.

I am a good investor. I bought a stock that is now losing money. These statements cause me cognitive dissonance. To avoid the pain of regret, I change the importance of the second thought. I am still a good investor; the timing was bad luck, but my purchase of the stock was still wise. So my decision is to hold the stock longer.

I am a good investor. I bought a mutual fund that is now losing money. To avoid this pain of regret, I add a third thought. The mutual fund manager is to blame. He is an idiot. Now I can sell the mutual fund with less pain of regret because it is not my fault. I am still a good investor.

The researchers find that investors in assets that have little chance of finding a scapegoat, like foreign and domestic stocks and warrants, show a strong reluctance to sell losers. Alternatively, investments in delegated portfolios, like mutual funds, show strong reverse-disposition effect (or much quicker selling of losers). Active mutual funds are quick to be sold when they lose money because they are easy scapegoats. Index mutual funds are not so quick to be sold because the managers don’t really make many decisions, so the blame goes back to the investor.

If I can find a scapegoat for my bad investment, I will sell it more quickly. If I am forced to blame myself, I hold the investment a little longer to see if I can break even.

Source: Tom Chang, David Solomon, and Mark Westerfield, 2014, “Looking for Someone to Blame: Delegation, Cognitive Dissonance, and the Disposition Effect.” Journal of Finance, forthcoming.

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