05. Disposition Effect Flashcards
What have Odean and Frazzini discovered?
They looked at trading financial assets over time.
There exists ample empirical evidence that individual investors and mutual fund managers have a greater propensity to sell stocks that have risen in value since purchase, rather than stocks that have fallen in value.
What is the puzzle?
Over the horizon that investors trade, stock returns exhibit momentum = stocks that have recently done well continue to outperform, on aerage, while those that have done poorly continue to lag behind.
Suggest: past recent winners will gain so you should hold them but it seems managers don’t do this = disposition effect.
Investors should concentrate their selling among stocks with poor past performance, but do the opposite.
Where else can we see the disposition effect?
In the real estate market.
Using data on Boston condominium prices from the 1990s, Genesove & Mayer (2001) find taht if we take 2 appartments A and B, such that the two apartments have the same expected selling price, but where A is expected to sell for less than its original purchase price while B is not, then the ask price that the seller posts for apartment A is significantly higher than that for B, on average.
What is the disposition effect?
Tendency to sell assets that have gained value (‘winner’) and keep assets that have lost value (‘losers’)
Which parts of prospect theory can explain disposition effect?
1) Reference point effect: The idea that people value gains and losses relative to a reference point = eg. The initial purchase price of shares.
2) Reflection effect: Tendency to seek risk when faced with possible losses, and avoid risk when a certain gain is possible = diminishing sensitivity. Decision makers are risk averse in the gain domain and risk-seeking in the loss domain.
These effects have been studied in different economic settings: eg. Market data, trading data from stock exchanges.
What is the reference point in the disposition effect?
Impressive amount of evidence of experimental evidence that risk attitudes do depend on reference points.
Often there are several possible reference points, however in financial settings purchase price of a stock natural reference point for evaluating a stock.
Using the purchase price of a stock as a reference point Shefrin and Statman (1985) found evidence that “investors tent to sell winners too early and ride losers too long” = disposition effect
Shefrin & Statman (1985): The disposition to sell winners too early and ride losers too long
What did O’Dean in 1998 investigate?
“Are Investors reluctant to realize their losses”
Used a database of 10.000 accounts from a large discount broker.
100.000 transactions between 1987-1993 with the reference price used: purchase price.
One issue: in upmarkets there are always more winners than losers.
Focusing on the frequency of winner/loser sales relative to the opportunity of winner/loser sales.
PGR = realized gains/(Realized gains+paper gains) PLR = realized losses/(Realized losses+paper losses)
What was the hypothesis of O’Dean?
Hypothesis: proportion of gains realized exceed proportion of losses realized (PGR>PLR)
Several different tests show a significant disposition effect.
Investors hold losers longer (a median of 124 days) than they hold winners (104 days).
When do investors show a disposition effect according to Odean?
Only time investors do not exhibit a disposition effect is at the year-end –> nearby tax advantage to selling losers.
Alternative explanation for empirical findings: investors are rational to keep losers/sell winners eg. Because they guess correctly that losers will rebound and winners will slip back in price.
Not confirmed: unsold losers return only 5% over the subsequent year, while winners that are sold would have returned 11,6%.
What conclusions are there for the disposition effect?
Empirical studies suggest that a disposition effect present in market date.
However: conclusive test of disposition effect using real market data difficult because investors’ expectations and individual decisions, cannot be controlled or easily observed in real markets.
Therefore: experiments
In experiments one can match individuals’ trading decision with the prices at which assets are bought, allowing a direct test for disposition effects.
How and why do we need to extend the disposition effect to different periods?
Theoritical examples have only showed one period.
Important: any empirical test for disposition effects tests joint hypothesis that prospect theory is correct and a particular specification of how investors choose reference points.
It can be discussed whether investors adjust reference point as prices change.
Eg. If current prices are the reference point from which gains and losses are valued, rather than the purchase price as assumed before –> should be expect a disposition effect?
When the reference point is the current stock, are winner and loser stocks treated different?
Investors keep stocks if a gamble over v(L) and v(-L) is better than v(O) and sell them otherwise
Winner stock will either gain G or lose -G; investors will keep them is the gamble over v(G) and v(-G) is better than v(0)
Loss aversion predicts that for equal chance gambles that the investors will always sell the lottery, regardless of whether it won or lot in the past = there should be no disposition effect if the reference point is current price.
This means = when reference point is current price, winner and loser stocks are treated identically.
Thus:
1) Disposition effects only arise when the original purchase price or another price of a previous period is the reference point.
2) When reflection effects cause investors to seek risk by holding losers and avoid risk by selling winners.
What did Weber & Camerer investigate? (1998)?
Weber & Camerer: The disposition effect in securities trading: an experimental analysis.
Derive hypotheses for markets in which prices are independent of individual investors’ trading behaviour = perfect competition
Main hypothesis: number of shares sold will be smaller for losing assets than for winning assets.
But it only makes sense to talk about winning and losing stocks relative to a reference point.
What was the hypothesis of Weber & Camerer?
Two possible reference prices: H1 takes the purchase price as the reference point.
H2 takes the previous period’s price as the reference point.
H1: purchase price reference point: Subjects sell more shares when the sale price is above the purchase price than when the sale price is below the purchase price
H2: last period reference point: Subjects sell more shares when the sale price is above the last period price than when the sale price is below the last period price
What was the third hypothesis in Weber & Camerer?
In most markets, selling a stock requires a deliberate action ( automatic selling and a possibility to re-buy). With no transaction costs, a rational decision maker should behave identically in both types of experiments.
If disposition effects are cause by a reluctance to deliberately incur losses, and an eagerness to guarantee gains, subjects who must sell assets deliberately will exhibit greater disposition effects than subjects who sell them automatically.
H3: disposition effects are smaller when assets are automatically sold than when selling is deliberate.
