The pattern that feels like good judgement

When something is working, there is pressure to lock in the gain before it reverses. When something is failing, there is pressure to hold on and wait for recovery. The result is a systematic tendency to exit profitable positions too early and sustain unprofitable ones too long.

Shefrin and Statman named this the disposition effect in a 1985 paper in the Journal of Finance. It is one of the most replicated findings in behavioural finance. And while it was first documented in investor behaviour, the mechanism operates identically in entrepreneurial decision-making — across product lines, marketing channels, hiring decisions, and strategic bets.

Why the architecture produces the inversion

The underlying mechanism is prospect theory’s value function, established by Kahneman and Tversky in 1979. In the domain of gains — when a strategy is performing above expectations — people become risk-averse. A certain smaller gain is psychologically preferred to a risky larger one. This is why winning strategies get exited: the mind is drawn toward locking in what exists rather than risking its reversal.

In the domain of losses — when a strategy is performing below expectations — people become risk-seeking. A chance of recovery is psychologically preferred to a certain smaller loss. This is why losing strategies get extended: closing means accepting a confirmed loss, while continuing preserves the possibility, however diminishing, of returning to the reference point.

The same psychological architecture that produces caution when ahead produces gambling when behind. The result is a systematic inversion of what rational decision-making would prescribe.

The mental accounts that make losses personal

Thaler’s mental accounting framework adds the structural layer. Every strategic bet opens a mental account with a reference point set at launch. Progress is tracked relative to that reference point — not relative to the overall portfolio, but to this specific bet. And the account is personal. The entrepreneur made the original call. The decision is attached to identity.

This is why closing a losing strategy feels categorically different from reallocating resources. Closing the mental account at a loss confirms that the original decision was wrong — and that the person who made it was mistaken. The longer the losing strategy has run and the more that has been invested, the harder closing it becomes.

Barry Staw’s escalation of commitment research found something directly relevant: people committed the most additional resources to failing courses of action precisely when they were personally responsible for the original decision. The self-justification pull increases with personal responsibility rather than decreasing. Entrepreneurs, who are almost always personally responsible for the original bet, are maximally susceptible to this pattern.

The emotional architecture underneath

The sunk cost fallacy provides the maintenance mechanism. Once sufficient time, money, and effort have been invested in a losing strategy, those past investments become a psychological reason to continue — independent of any assessment of future prospects. Entrepreneurs are particularly susceptible because identity and personal meaning are invested alongside financial resources, making the accumulated stake in any given strategy far larger than the financial figure alone.

The emotional layer beneath all of this is regret aversion. Selling a winning strategy early eliminates the risk of future regret — if it reverses after exit, the gain was at least locked in. Selling a losing strategy generates immediate regret by confirming the original decision was wrong. Holding the loser defers that regret indefinitely, even as the expected-value calculation strongly favours cutting.

Research confirms this pattern persists even among professionals whose role demands rational decision-making. Investment managers — with training and incentive structures designed to eliminate behavioural bias — still exhibit the disposition effect. The implication for entrepreneurs is sobering: expertise and sophistication do not reliably protect against it, because its roots are emotional and structural rather than informational.

The practical corrective

The most evidence-based structural antidote is replacing emotional reference points with empirical ones. Eric Ries’s pivot/persevere framework was explicitly designed to produce this shift. The pivot model asks not “how much have we invested in this?” but “what do the current metrics show, and what would we do if we were starting fresh with this information?” That reframe directly counteracts the mental accounting mechanism by locating the decision in the present rather than in the history of the bet.

Two specific practices. For winning strategies: before exiting, ask explicitly whether the same decision would be made if the strategy had been someone else’s. If the answer changes, pride or the endowment effect is driving the exit rather than the merit of the decision. For losing strategies: establish in advance — before launching any significant bet — what specific metric or threshold would constitute sufficient evidence to close the mental account. Pre-committed exit criteria are significantly more resistant to escalation of commitment than criteria established after losses have begun accumulating.

A book worth reading alongside this

Beyond Greed and Fear by Hersh Shefrin is the most comprehensive available treatment of the disposition effect and its practical consequences. Shefrin is one of the researchers who named the effect, and the book translates empirical trading data into a framework that applies directly to business decision-making. For any entrepreneur who recognises the pattern described here, it is the most rigorous and most practically grounded starting point.

Have questions about this article?

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This article is for educational and informational purposes only and does not constitute financial advice. Sources: Shefrin, H. & Statman, M. (1985), Journal of Finance, 40(3). Kahneman, D. & Tversky, A. (1979), Econometrica, 47(2). Thaler, R.H. (1999), Journal of Behavioral Decision Making. Staw, B.M. (1976), Organizational Behavior and Human Performance.