Behavioural Finance – The disposition effect

Behavioural Finance – The disposition effect

23rd August 2015 Ideas 1
By Alexander Joshi

In their 1985 paper in the Journal of Finance, Shefrin and Statman investigated the disposition that investors have to holding on to losing positions longer than winning positions. This became known as the disposition effect.

What is the explanation for the disposition to ‘ride losers’ even when the precepts of standard choice under uncertainty would prescribe realizing these losses? The explanation comes from one of the key insights from Behavioural Finance – the Nobel Prize winning Prospect Theory of Kahneman and Tversky.

Prospect theory can be neatly explained with the graph below. The main idea is that a loss will hurt us more than an equal sized gain, (they hurt roughly twice as much) which we can see is due to the difference in curvature of the valuation function. The difference between this value function and that in standard utility models is that it is defined on losses and gains from a given reference point (the price paid here) rather than overall levels of wealth. Behaving according to prospect theory leads us to act differently depending on whether we are in the domain of losses or gains. Investors hate losses and will gamble to avoid experiencing them, so they exhibit risk-seeking behaviour by holding losers. Conversely investors will want to lock in gains, so they exhibit risk-averse behaviour by selling winners.

Figure 1

Odean in 1998 tested this phenomenon using retail investor data, analysing the trading records of 10,000 at accounts at a large discount brokerage house. He finds that individual investors demonstrate a significant preference for selling winners and holding losers – over a year investors sell a higher proportion of their winners (15%) than their losers (10%), a result which is statistically significant. Losing positions were held a median of 124 days, whereas winning positions were held for only 104 days. Examining the day same effect in the context of day traders, Jordan and Diltz (2004) found that 62% of traders held losing trades longer than profitable ones, whilst 38% hold profitable trades longer.

There is evidence, however, that certain investor characteristics reduce the disposition effect. Whilst Odean aggregated across investors, Dhar and Zhu (2002) identified and examined individual differences in the disposition effect. Using demographic and socio-economic data to proxy the level of sophistication of investors, they found that trading experience reduced the effect, as did being wealthier and more educated. As in the Odean paper, Dhar and Zhu find that due to tax considerations, investors with high disposition effect will have lower after tax returns. This means that the bigger the disposition effect any one of the heterogeneous players in financial markets is prone to, the greater an investor could suffer from this bias.

The implication of this type of research is that we must make investors aware of such biases, especially those with lower incomes and little experience. In an industry where the quality of information decisions are made upon is absolutely crucial, perhaps we need to be gathering more information on other less obvious aspects to trading performance.

Alexander Joshi

References:

Dhar,R.,& Zhu,N.(2002). ‘Up close and personal: An individual level analysis of the disposition effect.’
Odean, T. (1998). ‘Are investors reluctant to realize their losses?.’ The Journal of finance, 53(5), 1775-1798.
Shefrin, H., & Statman, M. (1985). ‘The disposition to sell winners too early and ride losers too long: Theory and evidence.’ The Journal of finance, 40(3), 777-790.

About the author

Andrew Tan: Head of Technology and Website Development. 2nd year Economist at St. John's College. Please e-mail me with any inquiries/issues regarding the website at itofficer@marshallsociety.com!

1 Comment

  1. Harsha Perera

    19th September 2016
    Reply

    Interesting thoughts. Understanding reference points is critical to understand such biases. Thanks for posting.

Would you like to share your thoughts?

Your email address will not be published. Required fields are marked *

Leave a Reply