Disposition Effect Literature Review

Topics: Behavioral economics, Prospect theory, Stock market Pages: 7 (2526 words) Published: February 18, 2011
Disposition Effect
Research Project Management Skills

February 2011
By Emmanouil Kaldis,

Student: Emmanouil Kaldis 090043443
Behavioral finance and stock trading: what does the empirical evidence tell us about the disposition effect? INTRODUCTION.

One will think that when a stock is considered a winner the investor will be willing to hold this stock and try to get rid of the loser stocks. In contrast, studies have indicated that there is an anomaly affecting the investor’s behavior on stock trading. In Hersh Shefrin and Mein Statman’s report (1985) this anomaly is referred as a disposition effect and it is related to investors’ tendency on selling assets whose price has substantially increased too quickly but also holding losers too long. In other words, investors have a propensity to recognize gains while in the same time are less willing to recognize losses. Due to this fact, several papers have been published to illustrate the outcome the disposition effect has on several aspects of stock trading. Taking this in consideration, this paper focuses on the features of this effect in the extend of the angles these economists have presented their empirical evidence.

Following the Prospect Theory raised by Amos Tversky and Daniel Kahneman (1986), Shefrin and Statman (1985) take a further step and try to examine the decisions that might have a crucial impact on the decision making on realizing gains and losses in a market setting. Through their empirical evidence they include elements such as mental accounting, self-control, regret aversion and tax consideration in order to perceive these results and widen the prospect theory. In addition, Shefrin and Statman (1985) taking into consideration the work of Constantinides(1985), who studied a strategic optimization of short term- gains and losses through US tax code, came up the December effect. Constantinides(1985) argued that the returns on an investment can be either taxed in the short run with an ordinary income or in the long run with a lower rate. Whenever transaction cost appear, the normative theory of Constantinides(1985) in controversy to the disposition effect, suggests to realize immediately any losses; thus, loss realization should increase steadily making December the peaking month. Extending these findings, Shefrin and Statman (1985) use the disposition effect to test the normative theory and introduce a fifth aspect, named the potential gain, to the prospect theory giving the interaction results with the other elements. In addition, the evidence of the phenomenon of the disposition effect can be observed in real-world financial markets and according to Statman’s and Shefrin’s (1985) report tax considerations cannot on its own explain the pattern but only when combined with the disposition effect. In a more recent paper conducted by Terrance Odean (1998), the empirical evidence has shown that investors are willing to postpone taxable gains and continue holding profitable assets in their portfolio and should capture taxable losses by clearing all securities in a non-constant rate. Empirical evidence has mainly supported the disposition effect. The prospect theory, by Tversky and Kahneman, describes decisions in situations where there are several alternatives with uncertain results. This theory is descriptive and tries to explain investor behavior in real circumstances rather than optimizing decisions. Usually a reference point is set in order to compare the results, such as the value of a share when purchased. As mentioned above the disposition effect can be clarified by investors judging their gains and losses according to the initial price bought and the fact of being a rational investor with no abnormal behavior. In the prospect theory the value function is clarified over single outcomes. In order to value multiple outcomes Thaler (1985) introduced the mental accounting system, that explains...
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