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:
- Stocks with larger unrealized gains and those with larger unrealized losses (in absolute value) indeed outperform others in the following month.
- Return predictability is stronger on the gain side than on the loss side.
- A trading strategy based on the disposition effect generates a monthly alpha of approximately 0.5% to 1% with an annualized Sharpe ratio as high as 1.5. In comparison, for the same sample period, the Sharpe ratios of momentum, value and size strategies were 0.9, 0.6 and 0.7, respectively.
- In more speculative subsamples (i.e., stocks with lower institutional ownership, smaller size, higher turnover and higher volatility), the effects of unrealized gains and losses are stronger. Low institutional ownership may reflect less presence of arbitragers and small firms may be illiquid and relatively hard to arbitrage.
- The selling schedule weakens as the time since purchase increases, and the schedule becomes flat when the holding period exceeds 250 trading days.
In addition, An found that “selling propensities in light of capital gains and losses do not contribute unambiguously to the momentum effect: the tendency to sell more in response to larger losses tends to generate a price impact that opposes the momentum effect,” and concluded: “The finding in this paper is comparable to the strongest available evidence on price pressure.”
According to the 2014 paper “Who Trades on Momentum?”, that pricing pressure is exploited by more sophisticated institutional investors. The authors, Markus Baltzer, Stephan Jank and Esad Smajlbegovic, found that financial institutions—in particular, mutual funds and foreign investors, which generally are also institutional investors—are momentum traders, while private households are instead contrarians.
Sophistication & Contrarian Investors
Baltzer, Jank and Smajlbegovic also found that the degree of contrarian trading is negatively correlated with the level of sophistication of individual investors—the more sophisticated the investor, the less contrarian the behavior exhibited.
As proxies for investor sophistication, the authors used two metrics commonly found in the literature: investors’ average financial wealth and investors’ level of home-country bias. As financial wealth increased and home-country bias decreased, the contrarian behavior decreased.
In other words, the lack of financial sophistication is costly. Sophisticated institutional investors exploit the disposition-effect-driven behavior of individual investors, which creates momentum in stock prices.
The evidence from the aforementioned papers demonstrates that pricing anomalies, such as momentum, can persist long after they become well known through publication. It seems that human behavior doesn’t change, and limits to arbitrage can prevent more sophisticated investors from fully correcting mispricings.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.