Disposition Effect

Question 1

Disposition Effect

Answer 1

Prospect theory predicts the “disposition effect”

- This is the tendency to sell assets that have gained value (‘winners’) and keep assets that have lost value (‘losers’)

Question 2

Mental Accounting

Answer 2

Transferring assets is essentially accepting a loss and re-investing elsewhere

• Doing this explicitly, however, requires closing one mental account at a loss, and opening a new account.
• But by reinvesting the money, the investor’s original mental account does not need to be closed.

Question 3

Regret Aversion/ego maintenance

Answer 3

Investors are unwilling to accept and realise losses because the very act of doing so proves that their first judgment was wrong.

Question 4

Self control

Answer 4

Investors ride losers to postpone regret, and sell winners “too quickly” because they want to hasten the feeling of pride at having chosen correctly in the past. They will post pone regret for as long as possible.

Question 5

Shefrin and Statman (1985)

Answer 5

Their evidence shows very limited evidence of a disposition effect.

Question 6

Lakonishok and Smidt (1986)

Answer 6

Investors who do not hold the market portfolio may respond to large price increases by selling some of the appreciated stock to restore diversification to their portfolios.

Question 7

Lakonishock and Smidt (1986)

Answer 7

Investors who purchase stock on favourable information may sell if the price goes up, rationally believing that price now reflects this information, and may continue to hold if the price goes down, rationally believing that their information is not yet incorporated into price.

Question 8

Harris (1988)

Answer 8

Trading costs tend to be higher for lower priced stocks, and because losing investments are more likely to be lower priced than winning investments, investors may refrain from selling losers simply to avoid the higher trading costs of low-priced stocks.

Question 9

Odean (1998)

Answer 9

Obtained 10,000 accounts from a large discount broker

• Investors hold losers longer (a median of 124 days) than they hold winners (104 days)
• Across the entire year, investors realise about 24% of the gains they could realise by selling but they realise only 15% of their losses.
• Unsold losers return only 5% over the subsequent year, while winners are sold would have returned 11.6% (so the behaviour not explained by rational considerations)

Question 10

Weber and Camerer (1998)

Answer 10

Report experiments in which stock prices are positively correlated over time (no mean reversion) subjects still exhibit the disposition effect.

Question 11

Dar and Zhu (2004)

Answer 11

Look at individual-level behaviour. They find evidence that wealthier individuals and individuals employed in professional occupations exhibit

• Lower prevalence of the disposition effect
• A smaller magnitude of disposition effect among those exhibiting the effect.

Question 12

Grinblatt and Han (2005)

Answer 12

Examine the pricing and stock return implications fo the disposition effect.

• investors over-sell recent winners, which puts downward pressure on their price, hence, these stocks do not rise enough and are undervalued.
• Recent losers are not sold as much as they should be, so their price does not go down enough. These stocks become overvalued.

Gradually, over time, if these stocks return towards their true value, then we observe a form of momentum in prices.