5.2Disposition effect

People usually avoid actions that create regret and seek actions that cause pride. Regret is the emotional pain that comes with realizing that a previous decision turned out to be a bad one. Pride is the emotional joy of realizing that a decision turned out well.

Avoiding regret and seeking pride affects persons behavior and this is the true for the investors decisions too. Shefrin and Statman (1985) were the first economists who showed that fearing regret and seeking pride causes the investors to be predisposed to selling winners (potential stocks with growing market prices) too early and riding losers (stocks with the negative tendencies in market prices) too long. They call this the disposition effect.

Do the investors behave in a rational manner by more often selling losers or are investors affected by their psychology and have a tendency to sell their best stocks?

Several empirical studies provide evidence that that investors behave in a manner more consistent with the disposition effect. Researchers (Shapira, Venezia, 2001; Chen, at al, 2007) have found the disposition effect to be pervasive. They found that the more recently the stock gains or losses occurred, the stronger the propensity was to sell winners and hold losers. Investors usually hold in their portfolios losers remarkably longer than winners.

The disposition effect not only predicts selling of winners but also suggests that the winners are sold too soon and the losers are held too long. How such investor behavior does affect the potential results from his investments? Selling winners to soon suggests that those stocks will continue to perform well after they are sold and holding losers too long suggests that those stocks will continue to perform poorly. The fear of regret and the seeking of pride can affect investors wealth in two ways: first, investors are paying more in taxes because of the disposition to sell winner instead of losers; second, investors earn a lower return on their portfolio because they sell the winners too early and hold poorly performing stocks that continue with decreasing market results.

Interesting are the results of some other studies (Nofsinger, 2001) in which individual investors reaction to the news about the economy and about the company was investigated. Good news about the company that increases the stock price induces investors to sell stock (selling winners). In addition, controversially, bad news about the firm does not induce investors to sell (holding losers). This is consistent with avoiding regret and seeking pride. However, news about the economy does not induce investor trading. Investors are less likely than usual to sell winners after good economic news and these results are not consistent with the disposition effect. How such results could be explained? Investors actions are consistent with the disposition effect for company news because the feeling with the disposition effect of regret is strong. In the case of economic news, investors have a weaker feeling of regret because the outcome is considered beyond their control. This leads to actions that are not consistent with the predictions of the disposition effect.

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