The disposition effect is an anomaly discovered in behavioral finance. It relates to the tendency of investors to sell shares whose price has increased, while keeping assets that have dropped in value.
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Nicholas Barberis and Wei Xiong have described the disposition effect as "[o]ne of the most robust facts about the trading of individual investors.” The effect, they note, “has been documented in all the available large databases of individual investor trading activity and has been linked to important pricing phenomena such as post-earnings announcement drift and stock-level momentum. Disposition effects have also been uncovered in other settings—in the real estate market, for example, and in the exercise of executive stock options."
Barberis has noted that the disposition effect is not a rational sort of conduct because of the reality of stockmarket momentum, meaning “that stocks that have done well over the past six months tend to keep doing well over the next six months; and that stocks that have done poorly over the past six months tend to keep doing poorly over the next six months.” This being the case, the rational act would be “to hold on to stocks that have recently risen in value; and to sell stocks that have recently fallen in value. But individual investors tend to do exactly the opposite.”
Alexander Joshi has summed up the disposition effect as the disposition that investors have to holding on to losing positions longer than winning positions, saying that "investors hate losses and will gamble to avoid experiencing them, so they exhibit risk-seeking behaviour by holding losers. Conversely investors will want to lock in gains, so they exhibit risk-averse behaviour by selling winners.”
Shefrin and Statman study
The effect was identified and named by Hersh Shefrin and Meir Statman in 1985. In their study, Shefrin and Statman noted that "people dislike incurring losses much more than they enjoy making gains, and people are willing to gamble in the domain of losses." Consequently, "investors will hold onto stocks that have lost value...and will be eager to sell stocks that have risen in value." The researchers coined the term "disposition effect" to describe this tendency of holding on to losing stocks too long and to sell off well-performing stocks too readily. Shefrin colloquially described this as a "predisposition toward get-evenitis." John R. Nofsinger has called this sort of investment behavior as a product of the desire to avoid regret and seek pride.
Prospect theory
Researchers have traced the cause of the disposition effect to so-called "prospect theory", which was first identified and named by Daniel Kahneman and Amos Tversky in 1979. Kahneman and Tversky stated that, "losses have more emotional impact than an equivalent amount of gains," and that people consequently base their decisions not on perceived losses but on perceived gains. What this means is that, if presented with two equal choices, one described in terms of possible gains and the other described in terms of possible losses, they would opt for the former choice, even though both would yield the same economic end result. For example, even though the net result of receiving $50 would be the same as the net result of gaining $100 and then losing $50, people would tend to take a more favorable view of the former than of the latter scenario.
In Kahneman and Tversky's study, participants were presented with two situations. In the first, they had $1,000 and had to select one of two choices. Under Choice A, they would have a 50% chance of gaining $1,000, and a 50% chance of gaining $0; under Choice B, they would have a 100% chance of gaining $500. In the second situation, they had $2,000 and had to select either Choice A (a 50% chance of losing $1,000, and 50% of losing $0) or Choice B (a 100% chance of losing $500). An overwhelming majority of participants chose “B” in the first scenario and "A" in the second. This suggested that "people are willing to settle for a reasonable level of gains (even if they have a reasonable chance of earning more), but are willing to engage in risk-seeking behaviors where they can limit their losses. In other words, losses are weighted more heavily than an equivalent amount of gains.” This phenomenon is called the “asymmetric value function," which means, in short, that "a loss creates a greater feeling of pain compared to the joy created by an equivalent gain."
The prospect theory can explain such phenomena as people who prefer not to deposit their money in a bank, even though they would earn interest, or people who choose not to work overtime because they would have to pay higher taxes. It also plainly underlies the disposition effect. In both situations presented to participants in Kahneman and Tversky's study, the participants sought, in risk-averse fashion, to cash in on guaranteed gains. This behavior plainly explains why investors act too soon to realize stockmarket gains.
Avoiding the disposition effect
The disposition effect can be minimized by means of a mental approach called "hedonic framing". For example, individuals can try to force themselves to think of a single large gain as a number of smaller gains, to think of a number of smaller losses as a single large loss, to think of the combination of a major gain and a minor loss as a net minor gain, and, in the case of a combined major loss and minor gain, to think of the two separately.