Swedroe: How Investors Undermine Returns

April 23, 2018

There is a large body of academic evidence demonstrating that individual investors are subject to the “disposition effect.” It has been documented among U.S. retail stock investors, foreign retail investors, institutional investors, homeowners, corporate executives and in experimental settings.

Those suffering from this phenomenon, which was initially described by Hersh Shefrin and Meir Statman in their 1985 paper, “The Disposition to Sell Winners Too Early and Ride Losers Too Long: Theory and Evidence,” tend to sell winning investments prematurely to lock in gains and hold on to losing investments too long in the hope of breaking even.

Standard explanations for the disposition effect—such as tax considerations, portfolio rebalancing and informed trading—have been proposed and dismissed, leaving explanations that rely on investor preferences, such as prospect theory. Prospect theory implies a willingness to maintain a risky position after a loss and to liquidate a risky position after a gain. It also requires that investors derive utility as a function of gains and losses rather than the absolute level of consumption.

As Tobias Moskowitz explained in his 2010 AQR working paper, “Explanations for the Momentum Premium,” the disposition effect “creates an artificial headwind: when good news is announced, the price of an asset does not immediately rise to its value due to premature selling or lack of buying. Similarly, when bad news is announced, the price falls less because investors are reluctant to sell.” The disposition effect therefore creates predictability in stock returns and thus provides an explanation for the momentum premium.

Additional research into the disposition effect, including a 2012 study by Itzhak Ben-David and David Hirshleifer, “Are Investors Really Reluctant to Realize Their Losses? Trading Responses to Past Returns and the Disposition Effect,” has found that investors sell more when they have larger gains and losses.

Stocks with both larger unrealized gains and larger unrealized losses (in absolute value) will thus experience higher selling pressure. This temporarily pushes down current prices and leads to higher subsequent returns when future prices revert to their fundamental values.

Latest Research

Joseph Engelberg, Matthew Henriksson and Jared Williams provide the latest contribution to research on the disposition effect with their January 2018 study, “The Portfolio-Driven Disposition Effect.” They sought to determine whether the disposition effect operates at the individual asset level or at the portfolio level.

The authors’ data sample was the same as the one employed by Brad Barber and Terrance Odean in the study, “Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors,” which appeared in the December 2002 issue of The Journal of Finance. It consisted of 78,000 households with 158,000 accounts between January 1991 and November 1996.

Following is a summary of Engelberg, Henriksson and Williams’ findings:

 

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