Loss Aversion and the Disposition Effect: Why Doctors (and Other Investors) Hold Onto Bad Investments Too Long

We all like to think of ourselves as smart, savvy, and rational, right? As physicians, we undergo extensive education, endure grueling training, scour medical research, attend cutting-edge conferences, learn from colleagues, and continuously hone our craft—all so that we can make the right decisions at the right moments that might literally save lives. And when our patients do well, we feel a well-earned sense of pride. We helped save that person’s life.

But what happens when things don’t go well? What about the patient who doesn’t recover—or worse, dies? Even though we understand intellectually that many variables are outside our control, it’s easy and natural to feel regret. What if we had chosen a different direction? Recognized the symptoms sooner? Intervened more aggressively?

That feeling of regret can be profound. And it often outweighs the satisfaction we feel when things go right. In behavioral economics, this is known as loss aversion: the principle that losses hurt more than equivalent gains feel good.

Loss Aversion: The Psychology of Painful Decisions

Loss aversion can influence many areas of life. In medicine, it may show up in the form of prolonged self-doubt or depression after a bad outcome, even if it was unpreventable and countered by countless patient successes.

In the financial world, loss aversion was formally introduced by Daniel Kahneman and Amos Tversky in 1979 as part of their Nobel Prize–winning prospect theory. This theory explains how people make decisions under risk—not with cold rationality, but through emotional and cognitive biases.

Prospect Theory Highlights:

• People evaluate gains and losses relative to a reference point (like their current portfolio or expectations).

• Losses feel more painful than gains feel good.

• People are risk-averse when it comes to gains, but risk-seeking when trying to avoid losses.

• The way a choice is framed (as a gain or loss) can completely flip a person’s decision—even when outcomes are identical.

  
  

Here’s a classic example:

Scenario 1: You’re given $1,000 and must choose between:

• A guaranteed gain of $500

• A 50% chance to gain $1,000 and a 50% chance to gain nothing

  
  

  → Most people choose the sure $500.

  
  

Scenario 2: You’re given $2,000 and must choose between:

• A guaranteed loss of $500

• A 50% chance to lose $1,000 and a 50% chance to lose nothing

  
  

  → Most people now choose the gamble to avoid the sure loss.

  
  

Even though both scenarios have the same expected outcome, people change their behavior when losses are involved. Losses loom larger than gains—this is the heart of loss aversion.

The Disposition Effect: When Emotions Drive Investment Decisions

So how does this play out in real-world investing?

Simple: People sell their winners and hold their losers.

Investors feel validated when an investment rises in value and often lock in that gain quickly. But when a stock drops, they hesitate to sell, because it would mean admitting they made a bad choice. They cling to the hope that it will rebound. This pattern is called the disposition effect.

The classic study demonstrating this came from Terrance Odean in 1998, titled “Are Investors Reluctant to Realize Their Losses?” Using actual brokerage data from thousands of retail investors, he found that:

• Investors were more likely to sell winning stocks than losing ones.

• The Proportion of Gains Realized (PGR) was significantly higher than the Proportion of Losses Realized (PLR).

  
  

And here’s the kicker:

• The winners sold tended to outperform the market by an average of 2.35% over the following year.

• The losers held underperformed the market by -1.06%.

  
  

So, investors were consistently selling the good performers and clinging to the bad ones—a behavior that hurts long-term returns.

But Wait—There’s a Tax Angle, Too

To make matters worse, holding onto losing stocks also ignores a key tax planning strategy called tax-loss harvesting.

If you’re investing in a taxable account, you can use realized losses to offset gains, up to $3,000 per year (with additional losses carried forward). That means by selling a losing investment, you can either lower your income tax bill or sell a winner without incurring capital gains tax. But if you never sell your losers, you miss out on that advantage.

What Should Investors Do?

This doesn’t mean you should go out and intentionally buy losing stocks. Of course, the goal is to invest in assets that grow over time. But even the best investors will have losing positions—it’s inevitable. The key is not letting regret or pride dictate your decision after the fact.

If a stock or fund has underperformed consistently and no longer fits your investment strategy, don’t hold it just to avoid the pain of realizing a loss. Sometimes, it’s better to rip off the Band-Aid, take the tax benefit, and reallocate toward a better opportunity.

Also, don’t confuse this with selling during a general market downturn. That’s a whole different behavioral trap. If the market is broadly down, selling just locks in those paper losses. But if a specific investment is consistently underperforming relative to its peers or benchmarks, that's a sign it may be time to move on.

Final Thought for Physicians

Just like we rely on evidence-based protocols in medicine, we should strive for evidence-based investing. Understanding our own biases—like loss aversion—can help us become better decision-makers, both in the hospital and in the market.