The disposition effect is a well-known feature of trading that usually occurs in the stock market. The disposition effect is used to described a situation that investors tend to sell winning stocks too early and hold losing stocks for too long (Shefrin and Statman 1985). According to Shefrin and Statman(1985), they state that prospect theory by Kahneman and Tversky (1979) can be a cause of the disposition effect by defining over realized gain and loss. Also, it is shown by Odean (1998) that the potential explanation cannot explain the disposition effect: informed trading, rebalancing, and transaction costs. As well as Hens and Vlcek (2005), they also examine the connection between prospect theory and disposition effect based on assumption of myopic decision-making. Prospect theory, therefore, is hypothesized by many studies to be a cause of the disposition effect.
However, the behavior theory seems to give an explanation for this market anomaly. The study of Summers and Duxbury (2007) shows an evidence that an emotional balance between anticipated rejoicing or regret is an essential factor that causes the disposition effect beside realized gain or lose. Also, Krause, Wei and Yang (2006) support a behavioral theory, which they introduce an idea of behavioral bias between rational traders and non-rational traders, to be a cause of the anomaly.
The effect has been widely known not only in the stock market, but also the real estate market and the exercise of executive stock options (Barberis and Xiong 2009). Therefore, it is interesting to study what the main cause of the disposition effect is. Even there are broad of studies that try to explain the cause of the disposition effect, the main reason is still vague.
Therefore, this study aims to discover the causes of the disposition effect.
Literature Review
Many studies have tried to find the cause for this market anomaly and the reason of why investors behave like this in the stock market. The disposition effect is explained in the first part following by five main broad ideas of the causes of the disposition effect that try to explain what the cause of disposition effect is. One believes that prospect theory can clarify the disposition effect while the other group believes that this effect can be explained by mental accounting or regret theory reasons. Moreover, mean-reversion is supported by many studies to be the cause of the effect. Lastly, behavioral theory is used to explain the disposition effect. All of the explanations are studied and reviewed thoroughly in this part.
2.1 The Disposition Effect
The disposition effect is introduced by Shefrin and Statman (1985) as a situation that individual tends to sell winners stock too early and hold losers stock too long. The disposition effect has been confirmed experimentally by Weber and Camerer (1998) and on individual data by Odean (1998) but yet do not know what the cause of the disposition effect is. The study by Odean (1998) has tested the disposition effect by using the trading activity data to calculate the proportion of gains realized and the proportion of losses realized which the result exposes the disposition effect . Odean (1998) suggests three possible causes for the disposition effect. Those hypotheses are the information hypothesis, tax considerations and portfolio rebalancing. The study assumes that investors have private information that the stock will rebound, thus, this leads to the disposition effect. Also, Odean's (1998) second hypothesis suspect that the effect occurs because it can be used to compensate taxable gains in other asset, however, tax considerations fail to explain the effect. The last hypothesis by Odean (1998) expects that the effect is a consequence from the portfolio rebalancing; however, it has been argued that portfolio rebalancing is too complex for investors who exhibit the disposition effect. In addition, there are other papers about the disposition effect in stock markets in various countries that aim to study behavior and adopt Odean's method such as Brown et al. (2002) in Australia, Grinblatt and Keloharju (2001) in Finland and Shapira and Venezia (2001) in Israel. All of these studies show results of the disposition effect across stock markets in different countries but the cause of the effect remains unknown.
2.2 The Cause of the Disposition Effect
2.2.1 Prospect Theory
http://images.wikia.com/psychology/images/4/4e/Valuefun.jpg
Figure1: Prospect Theory Value Function
Kahneman and Tversky (1979) proposes the value function of prospect theory that shows "loss aversion" where the function is steeper for losses than for gains and it shows diminishing sensitivity as well. It can conclude from the theory that losses have more emotional impact than an equivalent amount of gains.
Prospect theory is used by Shefrin and Statman (1985) in order to explain the disposition effect. Their paper focuses on four main points to explain the primary causes of the disposition effect: Prospect theory, mental accounting, regret aversion, and self-control. Prospect theory is mainly used by them to explain that investors resist the realization of losses (either from selling profitable investments too soon, or retaining bad investments too long) to avoid losses of pride and feelings of regret. They believe that investors who experience gains will become a risk-averse, and investors who encounter losses will become risk-seeking to compensate what they lose. Therefore, they assume that the change in risk perception is the cause of the disposition effect. The idea of prospect theory is a main reason or an important factor of the disposition effect is supported by many recent studies such as Garvey and Murphy (2004), Jordan and Diltz (2004), Lehenkari and Perttunen (2004), and Dhar and Zhu (2006), and Barberis and Xiong (2009).
However, there are a number of studies that do not believe that prospect theory is the cause of the disposition effect such as Zuchel (2001), Kaustia (2008), Hens and Vlcek (2005), Krause, Wei and Yang (2006) and Summers and Duxbury (2007). The study by Zuchel (2001) states that the disposition effect is a result of sequential decision making and cannot be explained by prospect theory which is a one-shot decision making, therefore, any explanation that refer to prospect theory as a cause of the disposition effect cannot be used.
2.2.2 Mental Accounting
Another dimension that is used to explain the disposition effect is mental accounting. It is also one of the hypotheses which Shefrin and Statman (1985) state to be a potential explanation. In addition, Thaler (1985) explains that mental accounting is how individuals frame assets as current and future assets. They frame transaction costs and assign different levels of utility to each asset group. These decisions affect their behaviors and other related decisions. Mental accounting seems to have a similar pattern to prospect theory. Therefore, Grinblatt and Han (2004) combine prospect theory with mental accounting (PT/MA) which they believe to be the cause of the disposition effect. They state that PT/MA investors are risk-averse for some stocks but they are risk-seeking for others. To be a risk-averse or risk-seeking, it depends on whether the stock has generated a capital gain or a capital loss. Since investors tend to concentrate on individual stocks rather than on portfolio, Grinblatt and Han (2004) claims that PT/MA investors create the disposition effect.
2.2.3 Regret Theory
It is first stated by Shefrin and Statman (1985) that the disposition effect is a result from regret theory. Under the circumstance when investors realize losses from prior trade, they feel regret, while the realization of gains brings them pride, therefore they decide to sell the winners to make them feel better from the past decision and keep holding the losers to avoid the feeling of regret.
Another point of view is investors concern about the outcome; therefore, the fundamental assumption for this perspective is investors have to be concerned about how they feel after the decision is made. The regret theory is supported by Shiller (1998) that this emotional reason is a driver for investors to keep holding on to their losing stocks and accelerate investors to sell stocks that have their value increased. Moreover, Barberis and Xiong (2009) support a part of regret theory that the realized gain and loss could predict a disposition effect reliably.
However, the results of study by Bell (1982) and Loomes and Sugden (1982) show that regret theory cannot explain the disposition effect because the theory cannot link the previous gains or losses to the current decision that create the disposition effect. It is argued by Zuchel (2001) that it is too easy for professional traders to misunderstand realized gains and losses from paper gains and losses. Nonetheless, it is shown in the study by Coval and Shumway (2000), Locke and Mann (1999), and Heisler (1994) that there are investors who are unable to categorise realized gains and losses from paper gains and losses.
2.2.4 Mean Reversion
Mean reversion in prices occurs when investors believe that winners will have lower future returns than losers, therefore, they choose to sell winners. A low return is expected after a high return which investors are convinced to sell and after investors hold assets for sometimes and anticipate the price to rise, they will purchase extra shares (Zuchel 2001).
On the contrary, Andreassen (1987) found that if investors believe in mean reversion, they will have regressive forecast which the change in price level leads to investors' regressive predictions. The study makes the mean reversion less reliable in order to be a cause of the disposition effect because the effect focuses on the prior price changes not price level that lead to investors' extrapolative predictions. Moreover, merely weak empirical supports that mean reversion is a cause of the disposition effect and there is no strong evidence argue that investors do not believe in mean reversion. Moreover, the assumption of mean reversion is the desire to either sell or buy stock independently but it is likely to be able to apply only for the stocks that are already in the portfolio (Zuchel 2001). Therefore, it is difficult to use mean reversion to explain the disposition effect unless there is an assumption that investors already have stocks in their portfolios, otherwise, the cause of the disposition effect is still unclear.
2.2.5 Behavioral Theory
Even Prospect theory is thought to be the cause of disposition effect, Hens and Vlcek (2005), and Summers and Duxbury (2007) have raised the issue whether prospect theory is a true cause of the disposition effect or there is other explanation for this market anomaly. The recent evidence in Kaustia (2008) and Zuchel (2001) states that mental accounting, other psychological factors and behavioral theory should be considered as well since prospect theory alone is inadequate to explain the cause of the disposition effect clearly. Moreover, Krause, Wei and Yang (2006) report in their study that the informed trader tend to sell in the upward trend market and buy in the downward trend market which they call this a 'behavioral bias'.
Recent years, behavioral theory has become an importance explanation for many market anomalies. It was said by Elster (1998) that the economic view should integrate emotion which affects investing behavior and how emotion can affect decision making of investors. Therefore, behavioral theory is unavoidable to be suspected as a cause of the disposition effect. Previously, Shefrin and Statman (1985) consider the regret as a reason of an abnormal behavior of investors because it could cause investors to sell too soon to avoid the regret since regret is more painful than feeling pride from gain. The difference between regret and disappointment is studied by Zeelenberg et al. (1998) which their study report that the feelings individuals experience after a loss or gain that they do not responsible are disappoint and elate, orderly, but if they experience a loss or gain that they are responsible, they will feel regret and rejoicing, respectively. Summers and Duxbury (2007) explore how emotions may be an important part that can explain the economic behavior experimentally. They report that they do not find any evidence to confirm that prospect theory is a cause of the disposition effect. Instead, in order to prove that emotion causes the disposition effect, not only anticipated regret and rejoicing that are necessary for explaining the effect, but also choice and responsibility also take part. In explaining the cause of the disposition effect, their study emphasizes on the significance of emotional response which they prove that the change in emotion transform the behavior of investors.
3. Critical Evaluation
A number of studies try to uncover a true cause of the disposition effect such as prospect theory, mental accounting, regret theory, mean-reversion, and behavioral theory. All of the studies have tried to prove it in both empirical and experimental ways. However, it cannot be point out which one is the cause of the effect since each hypothesis has both cons and pros.
The prospect theory is the first reason to be argued that it causes the disposition effect (Shefrin and Statman 1985) since it refers to loss aversion and how people change their attitude of risk which causes the disposition effect. However, it is questioned by Hens and Vlcek (2005) if prospect theory can explain the disposition effect, therefore, their study argued that the disposition effect would not occur because investors would not sell the winners and hold the losers from the first place. They state that prospect theory is not a cause of the disposition effect but it occurs after the disposition effect which is explained as a backward looking behavior.
The second hypothesis is mental accounting. It is combined with prospect theory by Grinblatt and Han (2004) to explain the disposition effect that investors focus only on some stocks and overlook their portfolio which lead to the disposition effect. When investors frame their investment into two parts: a safe part and a risky part, they can take an opportunity to invest safely and riskily. The distinction between risk attitude leads to the disposition effect. Therefore, It is possible for this hypothesis to be true since Zuchel (2001) and Kaustia (2008) suggest that the cause of the disposition effect should not be only prospect theory but might include other factors as well.
Regret theory are mentioned as well in Shefrin and Statman (1985) as a potential explanation for the disposition effect. Investors feel regret after they know that it would have been better result of they chose to do differently, not by the result of realized loss. Therefore, when they gain in their next trade, they will sell quickly and hold to their losing stocks to avoid regret which creates the disposition effect. Another attitude about regret theory is a decision making which concerns how investors would feel at the end. The latter perspective about regret theory is not likely to be true since the disposition effect is a consequence from prior gain or loss but this perspective is a one-shot decision but the regret theory by Shefrin and Statman (1985) is likely to be a possible answer for the disposition effect.
Another possible explanation is mean-reversion which investors believe that the winners will have lower returns and the losers will have higher returns in the future. It can be seen that the mean reversion is caused from the change in price level, while the disposition effect based on the prior price changes. Therefore, mean reversion explanation divert a true answer for the disposition effect.
Recently, behavioral finance has turned to be a potential and effective tool to explain market anomalies. From previous explanation, it can be seen that most of the explanation (prospect theory, mental accounting, regret theory) relate to the feeling of gain and loss towards the result of investment. The role of emotion has taken a huge part to explain the disposition effect (Summers and Duxbury 2007). From behavioral theory, investors do not want to feel regret from realizing loss and the future price could be either up or down, therefore, they decide to hold the losers. Even investors decide to sell the losers which bring them losses; they would be compensated by experienced regret. Moreover, behavioral theory can explain the reasons why investors sell the winners. The explanations are they do not lose anything but receive gain from holding the winners and the price in the next period is unpredictable, selling or holding can be correct. Even they decide to sell the winners, they have nothing to lose but gain the profit from selling the stocks. It seems that behavioral theory has explanation of the disposition effect. However, there is a little research in area of behavioral theory as a cause of the disposition effect. Also, there might be other reasons that can explain the effect which there should be further study on this topic.
4. Conclusion
The disposition effect is a market anomaly that investors tend to hold loser stocks and sell winning stocks too early, which many researchers try to find the answer for it. The theory that is widely used to explain the effect is prospect theory by Kahneman and Tversky (1979). Other explanations that are well-known are mental accounting, regret theory and mean aversion which these theories have been discussed above. Moreover, behavioral theory is the latest explanation of the disposition effect which is tested experimentally by Summers and Duxbury (2007) and the answer for the anomaly is provided.
However, even each explanation has its own reason to support their answer; the cause of the disposition effect could be other reason above these explanations which is not yet to be found. As Kaustia (2008) and Zuchel (2001) state that it is possible answer could be other factors since prospect theory is clearly inadequate to explain the disposition effect.
