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>Home Page >Behavioral Finance >The Disposition Effect (also Loss Aversion):
Often, in their portfolio, people prefer to sell winners than losers. They act that way either out of pride, commitment, because of loss aversion, or to avoid regrets.
[Kahneman and Tversky] "analysis suggests that a person who has not made peace with his losses is likely to accept gambles that would be unacceptable to him otherwise".
[Folsom] "Fear is stronger than greed, which is why financial markets fall more rapidly than they climb. Most investors will say the sentence above is common knowledge. But, if so, why then do most investors fail to act on what they know? The failure is the behavior toward risk, namely: The average investor is risk-averse toward a known gain, but is risk-seeking toward a certain loss. When a stock goes up in price, individuals will sell too soon, especially when that stock has outperformed the broader market. They avoid risk by locking in the gain. When a stock goes down, individuals won't sell soon enough, especially when that loser has underperformed the market. They assume the risk of even deeper declines, rather than choose to cut their certain losses. Study after study bears out this truth".
The Disposition to Sell Winners Too Early and Ride Losers Too Long, Shefrin and Stateman, 1985
Meir Statman and I coined the term Disposition Effect, as shorthand for the predisposition toward get-evenitis. get-eventis afflicts both sophisticated and unsophisticated investors. Applied Kahneman and Tversky's notion of framing to the realization of loses. We called this phenomenon the Disposition Effect, arguing that investors are predisposed to holding losers too long and selling winners too early". Showing a reluctance to realize losses (disposition to "ride losers"). The Disposition Effect has four major elements: Prospect Theory, Mental Accounting, Regret Aversion and Self-Control. According to Prospect Theory an investor frames all choices in terms of potential gains or losses relative to a fixed reference point. Consider an investor who purchased a stock for $50 one month ago and the stock now is selling at $40. There are two outcomes to this situation. Sell the stock now and realize a loss of $10, or Hold the stock for one more period, with a 50-50 odds between losing an additional $10 or "breaking even". Prospect Theory imply that B will be selected over A. This seems to apply even if the odds of breaking even were something less than 50-50. Regret Aversion suggests that investors may resist the realization of a loss because it stands as proof that their first judgment was wrong. The quest for pride and avoidance of regret, lead to a disposition to realize gains and defer losses. Self-Control is portrayed as a conflict between a rational part (Planner) and a more primitive part and emotional individual action (Agent). Planner may not be strong enough to prevent the emotional reactions of the Agent from interfering with rational decision making. An example: traders clearly aware that riding losses was not rational, but could not exhibite enough self-control to close the position at a loss, thus limiting loss".
Disposition Matters: Volume, Volatility and Price Impact of a Behavioral Bias, Goetzmann and Massa, 2003
"The disposition effect was introduced to the finance literature by Shefrin and Statman (1985) as a characterization of the tendency of individuals to ride losses and realize gains. As such, it was based directly on Kahneman and Tversky's loss aversion framework. Loss aversion postulates that investors have the ''tendency to seek risk when faced with possible losses, and to avoid risk when a certain gain is possible". Loss aversion relies on studies in psychology that show that a decline in utility arising out of the realization of losses relative to gains induces investors not to sell losing stocks relative to winning ones. An important challenge to behavioral finance is to find a direct link between individual investor behavior and asset price dynamics. Few doubt that large numbers of investors behave irrationally and are prone to behavioral heuristics that lead to suboptimal investment choices, however the empirical evidence that these investors affect prices has been elusive. In this paper, we focus on the most widely documented behavioral heuristic among investors, the disposition effect. Statman and Thorley (1999) point out that the disposition effect, being based on a mental accounting framework, is stock-specific rather than related to the market as a whole. Thus it might not manifest itself as a pervasive, market wide risk factor. However, that is the proposition we test in this paper. We show that when the fraction of "irrational" investor purchases in a stock increases, the unexplained portion of the market price of the stock decreases. We further show that statistical exposure to a disposition factor explains cross-sectional differences in daily returns, controlling for a host of other factors and characteristics. The evidence is consistent with the hypothesis that trade between disposition-prone investors and their counter-parties influences relative prices. Not only does disposition matter at the individual security level, the aggregate behavior of disposition-prone investors appears to matter at the aggregate level, suggesting that behavioral effects might be important at the market-wide level".
Dying Out Or Dying Hard? Disposition Investors In Stock Market, OEHLER, HEILMANN, LAGER and OBERLANDER, 2002
"The phenomenon can be explained by prospect theory's idea that subjects value gains and losses relative to a reference point like the purchase price, and that they are risk-seeking in the domain of possible losses and risk-averse when a certain gain is obtainable".
The Disposition Effect in Securities Trading: an Experimental Analysis, WEBER and CAMERER, 1998
"The disposition effect can be explained by two features of prospect theory: the idea that people value gains and losses relative to a reference point (the initial purchase price of shares), and the tendency to seek risk when faced with possible losse, and avoid risk when a certain gain is possible".
Looking for direction - Buying High, Selling Low, Marmer
"Why investors buy high and sell low can be mostly attributed to pride-seeking behaviour as well as the fear of regret. Pride-seeking refers to the need to feel good about decisions. Fear of regret leads to avoidance of the pain and responsibility of poor decisions. Correspondingly, pride-seeking leads investors to buy high, by investing in funds with the latest hot track record, so that they can be winners and feel good. Fear of regret, meanwhile, causes investors to sell low as they hold on to losing funds too long in the hope of avoiding the inevitable loss".
The Disposition Effect: Explanations, Experimental Evidence, and Implications for Asset Pricing, ZUCHEL, 2001
"The disposition effect describes the tendency to sell winners (stocks with a paper gain) and hold losers (stocks with a paper loss).The disposition effect has been documented in many empirical studies. There is a large psychological literature on entrapment, escalation of commitment, and sunk cost, that studies phenomena that are very similar to the disposition effect. This literature suggests an explanation of the disposition effect based on cognitive dissonance theory".
What Makes Investors Trade?, GRINBLATT, KELOHARJU, 1999
We identify the determinants of buying and selling activity over a two-year period. We also find that the domestic investor categories generally engage in short-term contrarian behavior, especially in their tendency to sell stocks that have appreciated over the prior few days".
The Disposition Effect and Momentum, Grinblatt, 2001
disposition effect creates a spread between a stock's fundamental value - the stock price that would exist in the absence of a disposition effect - and its market price. Even when a stock's fundamental value follows a random walk, and thus is unpredictable, its equilibrium price will tend to underreact to information. The profitability of a momentum strategy, which makes use of this spread, depends on the path of past stock prices. Crosssectional empirical tests of the model find that stocks with large aggregate unrealized capital gains tend to have higher expected returns than stocks with large aggregate unrealized capital losses and that this capital gains "overhang" appears to be the key variable that generates the profitability of a momentum strategy".
Information Asymmetry, Price Momentum, and the Disposition Effect, STROBL, 2003
"Specifically, we show (i) that disposition effects arise quite naturally in a world with changing information asymmetry, (ii) that existing empirical tests rejecting an information-based explanation are inconclusive, and (iii) that disposition effects are consistent with price momentum".
The Courage of Misguided Convictions: The Trading Behavior of Individual Investors, BARBER and ODEAN, 2000
"This paper describes empirical tests of two predictions of behavioral finance: that investors tend to sell their winning stocks and to hold on to their losers and that, as a result of overconfidence, investors trade too much. We document that individual investors are 50 percent more likely to sell a winning investment than a losing investment".
Patterns of Behavior of Professionally Managed and Independent Investors, SHAPIRA and VENEZIA, 2000
"In this paper, we analyze the investment patterns of a large number of clients of a major Israeli brokerage house during 1994. We show that both professional and independent investors exhibit the disposition effect, although the effect is stronger for independent investors".