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

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.