Lecture 5–6: Disposition Effect Flashcards
(12 cards)
What is the Disposition Effect?
The tendency of investors to sell winning assets too early and hold on to losing assets too long.
What is the typical benchmark used to define winners and losers in the disposition effect?
The purchase price — gains/losses are evaluated relative to the investor’s cost basis.
Who first documented the Disposition Effect in financial markets?
Shefrin and Statman (1985)
What behavioral theory helps explain the Disposition Effect?
Prospect Theory — especially reference dependence and loss aversion.
How does loss aversion contribute to the Disposition Effect?
Investors dislike realizing a loss more than they enjoy realizing a gain of equal size, so they avoid selling losers.
What role does mental accounting play in the Disposition Effect?
Investors mentally separate each investment, leading them to evaluate individual gains and losses in isolation.
How does realization utility explain the Disposition Effect?
Realizing gains gives a psychological reward (‘realization utility’), which reinforces selling winners.
What empirical evidence supports the Disposition Effect?
Odean (1998): Retail investors more likely to sell winners than losers
Frazzini (2006): Mutual fund flows respond more to gains than losses
Barberis and Xiong (2012): Model linking realization utility to investor behavior
Is the Disposition Effect considered rational?
No — under standard finance theory, tax-loss harvesting and momentum suggest it’s often suboptimal.
How does the Disposition Effect impact market prices?
It can lead to underreaction to bad news and overvaluation of underperforming stocks.
What factors can reduce or eliminate the Disposition Effect?
Professional investors (less emotional attachment)
Performance-based compensation
Training and feedback
Portfolio design tools that aggregate performance
What is ‘break-even’ thinking and how does it relate?
The desire to hold losing stocks until they ‘break even,’ driven by psychological aversion to locking in losses.
