There is a large body of academic evidence demonstrating that individual investors are subject to the “disposition effect.” 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.
As Toby Moskowitz more recently explained in his 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 (momentum).
An explanation for the disposition effect may come from prospect theory, which implies a willingness to maintain a risky position after a loss and to liquidate a risky position after a gain. Prospect theory requires that investors derive utility as a function of gains and losses rather than the absolute level of consumption.
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.
On The Sale Of Extreme Winners And Losers
Li An contributes to the academic literature on the disposition effect with the 2015 study “Asset Pricing When Traders Sell Extreme Winners and Losers,” which appeared in The Review of Financial Studies. The study covered the period 1963 through 2013. Following is a summary of its findings: