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The Disposition to Sell
Winners Too Early and Ride
Losers too Long: Theory &
Evidence
By: Hersh Shefrin & Meir Statman
‘The Journal of Finance’ Dec 1984
Presented by: Ashraf Yaghi
Introduction
• For over thirty years individual decision
makers have not behaved in accordance
with the expected utility theory
• The tendency to sell winners too early and
ride losers too long is referred to as the
‘disposition effect’
Disposition Effect
•
The ‘disposition effect’ has four major
elements
1.
2.
3.
4.
The prospect theory
Mental accounting
Regret aversion
Self-control
Prospect Theory
•
According to the Prospect theory the investor
goes through 2 stages of decision making
1. The ‘editing stage’ frames all choices in terms
of potential gains and/or losses relative to a
fixed reference point.
2. The ‘evaluation stage’ in which the decision
maker employs an S-shaped valuation function
(meaning a utility function on the domain of
gains and/or losses) which is concave in the
gains region and convex on the loss region.
Prospect Theory
•
Consider an investor who purchased a
stock for $50 one month ago and the
stock now is selling at $40
-There are 2 outcomes to this situation-
1. Sell the stock now and realize a loss of $10
OR
2. Hold the stock for one more period, with a
50-50 odds between losing an additional $10
or “breaking even”
Prospect Theory
• Since the choice between these two is
associated with the convex portion of the
S-shaped value function, prospect theory
implies that B will be selected over A.
• This seems to apply even if the odds of
breaking even were something less than
50-50.
Mental Accounting
• There are 2 kinds of tax on stock returns.
1. Short-term gains (less than a month) is taxed
like income
2. Long-term gains is taxed lower
• Lets consider an investor who experienced a
price decline in his stock. Then this investor will
only sell to exploit the difference between short
and long term tax.
Mental Accounting
• The IRS requires that thirty days pass before a
stock can be repurchased, if the investor wants
to get a tax advantage stemming from its sale.
• Wash sale regulations can be neutralized
through a “swap” by replacing a stock sold for
tax purposes with a stock that has identical
return distribution.
• The main point here is that the swap reduces the
investors tax liability leaving him with an equal
gamble.
Seeking Pride & Avoiding Regret
• The simple fact is investors may
resist the realization of a loss
because it stands as proof that
their first judgment was wrong.
• The quest for pride, and
avoidance of regret lead to a
disposition to realize gains and
defer losses.
Self-Control
• Self-control is portrayed as a conflict
between a rational part (planner) and a
more primitive and emotional individual
action (agent).
• Planner may not be strong enough to
prevent the (emotional) reactions of the
agent from interfering with rational
decision making.
• An example, traders clearly aware that
riding losers was not rational, but could
not exhibit enough self-control to close
the position at a loss, thus limiting loss.
Self-Control
•
Different pre-commitment techniques to
control the ‘agents’ resistance to realizing
losses :
1.Predetermined percentage loss
(e.g., ten percent)
2. Stop-loss order
3. Funding an emergency
Self-Control (December Trading)
• The month of December seems to have
abnormal trading volume. The trading constitutes
tax loss selling which reflects self control.
• This occurs because many investors want to
benefit from the tax rebate and this is considered
a rational act by many investors.
• So we can perceive that self motivation is easier
in the month of December than any other month
because of its deadline characteristic.
Empirical Evidence
• The major interest is whether investors time the realization
of their losses differently than gains, and if so what is the
nature of the difference.
• This evidence concerns the time that passes between
when an investor buys a stock and the point where he
sells it.
• Tax considerations suggest that losses should be realized
while they are short-term, while gains should be realized
only when they are long-term. However the disposition to
sell winners early and ride losers too long is the opposite.
Empirical Evidence
• Individual trades by selected investors
between 1964 and 1970
• A ‘round trip duration’ denotes the length of
time that an investor holds a stock before
selling it
Empirical Evidence
Empirical Evidence
• Approx 40% of all realization are losses
• What do we infer about tax motivated as
opposed to disposition effect from the data
Suppose that investors trade to take advantage
of the tax option and not subject to the
disposition effect. Then we find there are few
gains realized when they are short-term for 2
reasons.
1.Tax rate is high on such gains
2.Transaction costs involved in frequent trading
Empirical Evidence
• Thus the number of transactions where a
gain is realized should be very low for
roundtrip durations less than 6 months
• On the other hand gains from high and
medium variance stocks should be
realized as soon as the become long-term.
So the long number of transactions should
be high.
Empirical Evidence
• We conclude that taxinduced trades form minor
portion of all trades.
• Another inference is that
Disposition effect offsets tax
motivated traders.
Conclusion
• Tax realization alone cannot alone explain the observed
patterns of loss and gain realization. Both the disposition
effect and tax considerations are consistent together.
• The four major elements of the ‘disposition effect’ places
this behavioral effect (sell winners and hold losers) into a
wider theoretical framework.