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

1. 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

2. 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’

3. Disposition Effect • The ‘disposition effect’ has four major elements • The prospect theory • Mental accounting • Regret aversion • Self-control

4. Prospect Theory • According to the Prospect theory the investor goes through 2 stages of decision making • The ‘editing stage’ frames all choices in terms of potential gains and/or losses relative to a fixed reference point. • 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.

5. 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- • 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”

6. 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.

7. Mental Accounting • There are 2 kinds of tax on stock returns. • Short-term gains (less than a month) is taxed like income • 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.

8. 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.

9. 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.

10. 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.

11. 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

12. 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.

13. 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.

14. 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

15. Empirical Evidence

16. 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

17. 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.

18. Empirical Evidence • We conclude that tax-induced trades form minor portion of all trades. • Another inference is that Disposition effect offsets tax motivated traders.

19. 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.