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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".
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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". |
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