“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.
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 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.