The Disposition to Sell Winners Too Early and Ride Losers Too Long: Theory and Evidence

Abstract

One of the most significant and unique features in Kahneman and Tversky's approach to choice under uncertainty is aversion to loss realization. This paper is concerned with two aspects of this feature. First, we place this behavior pattern into a wider theoretical framework concerning a general disposition to sell winners too early and hold losers too long. This framework includes other elements, namely mental accounting, regret aversion, self-control, and tax considerations. Second, we discuss evidence which suggests that tax considerations alone cannot explain the observed patterns of loss and gain realization, and that the patterns are consistent with a combined effect of tax considerations and the three other elements of our framework. We also show that the concentration of loss realizations in December is not consistent with fully rational behavior, but is consistent with our theory. IT HAS BEEN WELL-KNOWN for over thirty years that individual decision makers do not behave in accordance with the axioms of expected utility theory. The famous Allais paradoxes [1] have made this point abundantly clear. Recent work by Kahneman and Tversky [15], Machina [19], and others has sought to provide a theory which describes how decision makers actually behave when confronted with choice under uncertainty. One of the key findings by Kahneman and Tversky concerns decision makers whose recent gambling history reflects losses. They indicate that their analysis suggests that a person who has not made peace with his losses is likely to accept gambles that would be unacceptable to him otherwise (p. 287).Kahneman and Tversky's finding was obtained in a controlled experimental situation. Economists tend to treat experimental evidence with some caution and are reluctant to conclude automatically that similar features will be exhibited in real-world market settings. Indeed, it is important to look at market behavior in order to ascertain whether such behavior patterns can be discerned in actual trading.In this paper, we examine decisions to realize gains and losses in a market setting. Specifically, we focus attention on financial markets and seek to determine whether investors exhibit a reluctance to realize losses (disposition to "ride * University of Santa Clara, Leavey School of Business. We would like to acknowledge the helpful remarks made on earlier versions by

Factors Affecting the Disposition Effect in Tehran Stock Market

“…Odean (1998) has investigated disposition effect by analyzing the information related existing transaction accounts in a brokerage (Pempin, 2009). He found that stockholders, on the whole, prefer loser stocks over the winner stocks which are confirmed by other studies (Shefrin & Statman, 1985;Odean, 1998;Weber & Camerer, 1998;Locke & Mann, 2000;Grinblatt & Keloharju, 2001;Ranguelova, 2001) that come across similar findings.…”

“…Disposition effect was first introduced by Shefrin and Statman (1985) to describe the dominant tendency of investors to keep loser stocks for a long term but to sell winner stocks too early. They employed a model to explain why investors tend to sell winner stocks too early and to hold loser stocks for a long time.…”

“…Mental accounting has been used to account for economical phenomena. Mental accounting as a bias plays an important role in decisions made about household budget (Thaler, 1985), transactions in stock exchanges (Shefrin & Statman, 1985) and consumption life cycle (Shefrin & Statman, 1985). Kahneman and Turesky (1981), Thaler (1985), Kahneman and Lovallo (1993) stated that stockholders divide all revenues into several small parts; each called a mental account while the whole process is called mental accounting.…”

“…Shefrin and Statman (1985) have demonstrated that regret is an emotional state by which the effected individual imagines that if he had taken another decision in the past other than what he really took, he may have been got better results (Shefrin & Statman, 1985) and this is another factor which may lead to disposition effect. Regret aversion is a vital factor which accounts for why it is difficult for investors to indentify profit and loss.…”

“…Identification of loss is a signal of the investor's misjudgment. Shefrin and Statman (1985) also believe that a sense of regret resulting from loss is stronger than a feeling of pride due to gaining a profit. According to Thaler (1980) regret theory is a motivational decision making theory with the main assumption that people are concerned about the feeling they experience due to outcomes of the decisions they have made (Thaler, 1980).…”