Are Investors Reluctant to Realize Their Losses?

Topics: Stock, Prospect theory, Null hypothesis Pages: 9 (3095 words) Published: May 11, 2013
Behavioral Finance

Article Presentation

“Are Investors Reluctant to Realize Their Losses”

Are Investors Reluctant to Realize Their Losses?
* This article was written by Terrance Odean.
* This article was published by “Journal of Finance” in 1998.

Aim of the Study
By writing this article Terrance Odean wants to examine the tendency to hold losers too long and sell winners too soon. This tendency has been labeled Shefrin and Statman as a “disposition effect.” Terrance Odean defined four components in order to explain disposition effect and also put some test to measure investor’s tendency. Based on a these tests Terrance Odean tries to show that which effects influence the investor’s tendency. Disposition Effect

Shefrin and Statman show that fearing, regret and seeking pride causes investors to be predisposed to selling winners too early and riding losers too long. They call this the disposition effect. T. Odean used four components to describe disposition effect. Prospect Theory

Prospect theory assumes that when people faced with choices involving simple two and three outcome lotteries they behave as if maximizing an S-Shaped value function. The function relies on reference point which is useful to explain gain and losses. In this article we assume that investor’s reference point is price of stocks. Investor’s willingness to pay average price for stocks is taken as a reference point. Then, when investor sells the stock if it is above the average, it is gain. Also, if it is below the average, it is loss. The function is concave in the domain of gains and convex in the domain of losses. It is also steeper for losses than for gains, which implies that people are generally risk averse. That is what we call prospect theory for disposition effect. An Alternative Behavioral Theory

Investors suppose that their losers are going to outperform better than their winners in the future. For this reason they keep losers in their hands. However, the situation is different from their assumptions. Investors think that they are rational but actually they are irrational about holding losers. Since, losers will not bring more gain than winners. They should make a peace with their loss instead of being persistent. Taxes

When investors purchase taxable investment, they want to make profit from taxes so they hold it. When there are transaction costs, and no distinction is made between the short-term and long-term tax rates, investors should gradually increase their tax-loss selling from January to December. Dyl (1977), Lakonishok and Smidt (1986), and Badrinath and Lewellen (1991) report evidence that investors do sell more losing investments near the end of the year. Investors do that as a self-control measure. When losers are sold in December, it is loss again but investors get tax benefit upon their investments. Previous Studies

Investors may be irrational when deciding to hold losers and sell winners but there are also rational reasons why investors may choose to hold their losers and sell their winners. 1) In order to diversify portfolios, investors may sell their appreciated stocks. 2) When investors heard something about price change they could sell or hold their stocks depend on the situation. 3) Losing investments are more likely to be lower priced and lower priced stocks have higher trading cost. So, investors hold their losing investments in order not to pay higher trading costs. Data & Sample

The data for this study are provided by a nationwide discount brokerage house. From all accounts active in 1987 (those with at least one transaction), 10.000 customer accounts are randomly selected. The data are in two files: a trade files, a security number to CUSIP (identifies North American financial securities) file are used in this study. The trade files includes the records of all trades made in the 10.000 accounts from January 1987 through December 1993.This file has 162.948 records, each...
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