The Disposition Effect and its Influence on Investment Decisions
Leroy Gross was a stock broker on Wall Street and the author of the book “How to sell intangible assets”. According to Gross, many clients would refuse to sell anything at a loss because they did not want to give up the hope of making money on a particular investment. Being a stock broker for many years, Gross realized that it was easier to convince his clients to close on losing positions by framing the transaction as a transfer. Rather than advising his clients to sell their losing stocks, Gross was proposing another investment to transfer the assets into immediately. What are some of the behavioural aspects that Gross’ clients were driven by? This week we will discuss one of the most well-known tendencies in behavioral finance about trading of individual investors, the Disposition Effect, as well as talk about such related concepts as regret, loss aversion and self-control.
The disposition effect can be described as – ‘an individual investor has a greater propensity to sell a stock that has gone up in value than the one that has gone down’. The effect has been documented in all the available large databases of individual investor trading activity and has been linked to important pricing phenomena, such as post-earnings announcement drift and stock-level momentum. In this blog we will introduce the concept of Disposition Effect and its influence on real-life financial decision making. We will put the theory behind it into context by tracing its original assumptions back to the Prospect Theory. We will also elaborate on the biases responsible for the disposition effect, followed by a presentation of real-life examples that are consistent with the effect of disposition.
Prospect Theory and the Disposition Effect
The idea that people value losses more than gains suggests an overall risk aversion in financial decision making. Over thirty years now, it has been well-known that investors do not behave in accordance with the expected utility theory. We can trace the cause of the disposition effect back to the Prospect Theory, a theory first introduced by Amos Tversky and Daniel Kahneman in 1979. They stated that decision making under uncertainty often involves an approach of aversion to loss realization. The main concept of Prospect Theory is that the carriers of value are not the final outcomes (absolute values), but rather the changes in wealth (relative values). Put simply, in the presence of uncertainty, the decision makers interpret their potential outcomes as either gains or losses based on their reference points – being their current wealth or the purchase price of an asset. Kahneman and Tversky also found that people value losses more than gains. Thus, decision makers are particularly averse to losing what they already have and are generally less concerned about gains.
Regret Aversion and the Trying-to-break-even Effect
The convex shape of the loss function in prospect theory suggests excessive risk-seeking in the domain of losses. Loss aversion suggests that investors are disproportionately risk averse in order to avoid the pain associated with financial loss. According to Thaler & Johnson, when decision makers experience prior losses, outcomes that offer an opportunity to “break even” are especially attractive. This phenomenon is called the trying-to-break-even effect and it involves the characterization of outcomes as either “gains” or “losses”. The characterization is dependent on the reference point and is a perfect example of mental accounting – a concept we have touched upon in our previous blogs. The reference point of an investor, when evaluating a “hold or sell” decision, is usually the purchase price of the stock. If the stock’s value is above the price that the investor paid for acquiring it, the trade is considered to be a “gain”. If the value of the stock is less than its purchase price, the trade is considered to be a “loss”. Since selling a losing stock involves no risk – as it has a sure outcome of realizing the loss immediately, assuming lower overall risk-aversion in the domain of losses – investors would prefer to take the gamble and hold onto the losing stock in the hope of it becoming a “winner” in the future. It has been shown that hoping-to-get-even is a well-observable behavior among investors and it is strongly connected to the theory of regret aversion.
Aversion of regret provides an important explanation on why investors may want to avoid realizing losses. Investors tend to be hesitant to accept the reality of a loss, because it stands as a proof of them being wrong about their investment decision. Regret aversion posits that investor indecision and failure to take action typically stem from wanting to avoid responsibility for a poor result. In this context, regret is defined as a negative emotion associated by the ex-post knowledge that a different decision would have fared better than the one actually chosen. The existence of regret as a feeling should not alone explain why investors are selling their rising stocks faster than their losing ones. Indeed, one of the explanations lies in the asymmetry between the strength of pride and regret (the emotion of regret being stronger). Regret can also occur when selling a winning stock too early with profits and watching it increase further after the position has been closed.
Examples – Disposition Effect Under Real Market Conditions
The findings of Kahneman and Tversky were based on experiments conducted in controlled environments. Due to the controlled quality of those experiments, many economists are hesitant to accept the supposition that the same behavior would be observable under real-life market conditions. Economists Shefrin and Statman believe an important factor in explaining disposition effect can be the lack of self-control. Their study of professional futures traders revealed a tendency of traders to let their losses ride. Another finding suggests that investors ride losers to postpone the feeling of regret. Thus, it is the emotional reactions associated with closing a losing position that prevents traders from doing so. Interestingly, Kahneman & Tversky also argued that the emotional reactions associated with regret are strong enough to prevent relational decision making in such situations. Even though traders are aware of their behavior being irrational, their fear of regret and lack of self-control avoids them in limiting their losses. Analyzing the NYSE between 1981 and 1985, it was found that stocks with gains had positive abnormal value while stocks with losses had negative abnormal values. A higher volume in stock with gains was observable compared to a lower volume in stock with losses. This phenomenon is consistent with the disposition effect.
Mutual Funds and the Emotional Sunk Cost
An area in which investors do not seem to exhibit the disposition effect is trading with mutual funds. It was found that in the case of mutual fund ownership, investors are more willing to close losing positions and less willing to close winning ones. The explanation is that investors are not that reluctant to realize losses if they can blame someone else for the decision. The reason being their smaller emotional sunk cost associated with the investment. By being able to blame someone else for the wrong investment decision, investors were found to feel less regret. It is feeling less regret that enabled them to let go of their losing stock more easily. Disposition effect is not only observable among non-sophisticated investors. Professional traders and mutual fund managers were also found to realize gains at a faster rate. For example, researchers Dhar & Zhu found that new managers of mutual funds have no regret-aversion towards their inherited positions and tend to sell non-performing positions at a higher rate.
What is then the explanation for Gross’ solution?
Revisiting the story of a Wall Street broker, Gross, we can now attempt to find a theoretical justification for why his solution actually worked! In particular, when Gross framed a transaction as a transfer, the clients that transfer their assets into another investment did not close their mental accounts at a loss and, therefore, were able to come to terms with their losses.
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Gross, L. (1982). The Art of Selling Intangibles. 1st ed. New York: New York Institute of Finance.
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