Swedroe: Understanding The Disposition Effect

February 08, 2019

Avoiding The Disposition Effect

Marc Wierzbitzki and Sebastian Seidens provide the latest contribution to the literature on the disposition effect with their October 2018 study, “The Causal Influence of Investment Goals on the Disposition Effect.” They begin by noting that experiments found that the disposition effect can be substantially reduced (by 25%) when making a stock’s purchase price less conspicuous.

A possible explanation for this could be that when purchase prices are omitted and the investment’s value has depreciated, investors experience a lesser degree of regret for having made a bad investment. They are thus more willing to divest losing assets.

Experiments also found that when investors employ automatic selling mechanisms in the form of limit orders, they exhibit a significantly lower disposition effect—limit orders serve as an ex-ante self-control mechanism. Another experiment found that simply providing a rational or emotional warning message about the disposition effect before trading decisions can be submitted is sufficient to reduce the bias.

In their study, Wierzbitzki and Seidens investigated the influence of establishing investment goals and their presentation format on the disposition effect in an experimental setting.

They write: “Our motivation stems from the fact that goal theory can provide an unobtrusive and straightforward to implement debiasing mechanism. This is because goals make the investor focus on the overall performance of their investment instead of separating it into several mental accounts that are evaluated individually. Thereby, they also enhance investors’ self-control.”

They noted that it “has been found in more than 500 empirical studies that setting specific, challenging goals is associated with better performance than setting unspecific or so-called ‘do-your-best’ goals.”

Psychologically, goal theory is founded in self-regulation. With regard to the disposition effect, the authors expected that exposing investors to an investment goal would enhance their self-control—they would be inclined to realize losses more quickly and hold on to paper gains longer in order not to miss their investment goal.

The Experiment

In the setup of their experiment, assets were labeled Stock A through Stock F, and subjects were told they would participate in an “experiment about stock market decision-making.” The price developments of all six shares followed a distinct two-stage random process.

In the first step, it was determined individually whether the price of each share would increase or decrease. Each share was associated with a certain probability of a price increase or decrease; hence, prices could not remain constant from one period to the next. The probabilities remained unchanged over the duration of the experiment, and were designed in a way such that there were clearly favorable, neutral and unfavorable stocks.

Subjects were told the probabilities in the instructions preceding the experiment. However, they did not know which probabilities were associated with which stocks.

Therefore, they would have to observe stock prices carefully to infer the more favorable stocks—the stocks with the greatest number of past price increases were most likely to exhibit the most price increases in subsequent periods. Hence, participants should adopt a trading strategy that invested in these stocks for optimal performance.

The occurrence of the disposition effect thereby cannot be explained by investors’ belief in mean reversion. Subjects were explicitly told they were to invest their initial endowment of $10,000 such that they accumulate $11,000 by the end of period 14.

Following is a summary of their findings for the 160 subjects:

  • Subjects with a positive disposition effect accumulated lower final assets than subjects with a negative disposition effect—consistent with prior research, the disposition effect was associated with worse trading performance.
  • Providing investors with a specific investment goal they were primed to achieve in the experiment significantly reduced their disposition effect.
  • Enhanced self-control and refraining from mental accounting seemed to cause investors to hold on to paper gains longer. Though their behavior with regard to loss realization did not change, they exhibited a reverse disposition effect overall.
  • Aggregating their portfolio’s performance in a single graphical representation did not have any significant effect on their subjectivity to the disposition effect.

Wierzbitzki and Seidens concluded: “Goal theory can provide a simple and unobtrusive way in which the disposition effect can be debiased in a sophisticated experimental setting.”

Summary

The well-documented disposition effect not only provides us with explanations for behavioral-based anomalies, such as momentum, but also with an opportunity to better understand how our behaviors can negatively impact our results.

We cannot learn from our behavioral mistakes unless we are aware of them. And once we aware of our biases, we can take actions to minimize the effect by setting investment goals and establishing rules (such as when to harvest losses).

Having a written and signed investment plan, including a rebalancing table, along with defined goals, can help you avoid emotion-driven mistakes that lead to poor outcomes.

Do you have such a plan?

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.

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