Swedroe: Understanding The Disposition Effect

February 08, 2019

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.

Handling Risky Positions

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.

Other behavioral explanations include: 1) mental accounting (how individuals classify personal funds differently and are therefore prone to irrational decision-making in their spending and investment behavior); 2) pride-seeking and regret aversion; and 3) lacking self-control.

As Toby Moskowitz explained in his 2010 AQR working paper “Explanations for the Momentum Premium,” the disposition effect “creates an artificial head wind: 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,” 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.

Recent Research

Joseph Engelberg, Matthew Henriksson and Jared Williams contributed to the research on the disposition effect with their March 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. They found:

  • There is no disposition effect for a stock if the remaining portfolio is up. However, if the remaining portfolio is down, a stock with a gain is more than twice as likely to be liquidated than a stock with a loss. (Note that, at least for taxable accounts, this is exactly the opposite of what efficient tax management would require, which is the harvesting of losses). The results were significant at well below the 1% level of statistical significance (t-stats were in the 20s).
  • The authors reached the same results when they considered proxies for investor sophistication, such as professional jobs or high income.

Engelberg, Henriksson and Williams concluded that the most likely explanation for the effect is that “investors derive utility from both paper gains and realized gains and that they take utility by realizing gains when they have disutility from unrealized losses.” The authors add: “When their portfolio has paper losses, they compensate by realizing gains.”

They explain: “When an investor’s overall portfolio is down, the investor will receive a lot of negative utility from the paper losses, so she should be especially likely to seek a burst of positive utility from realizing a paper gain to offset some of the negative utility she has received due to the poor performance of her portfolio. This could explain why we find such a strong disposition effect when an investor’s portfolio is down.”

Another interesting finding was that, when a stock is at a gain but the portfolio is at a loss, upon realizing the gain, investors are most likely to keep the proceeds in cash—it is important to investors that the gain “stay” realized.

The bottom line is that the disposition effect entails adverse consequences for investors’ investment performance. For example, in his 1998 study “Are Investors Reluctant to Realize Their Losses?”, Terrance Odean found that the stocks investors sold too quickly as a result of the disposition effect continued to outperform over the subsequent periods, while the losing assets these investors held on to for too long remained underperformers, which raises the question, Can investors be trained to avoid this bias?

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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