The Disposition Effect, a Behavioral Bias in the Financial Market. : A Survey of the Disposition effect.

Abstract

This paper is a survey of existing papers on the disposition effect, which may be described as a tendency for investors to ride losers too long and sell winners too soon. It provides a comprehensive overview of the existing work done on the disposition effect and further analysis should be done in order to make a theoretical framework that may explain the disposition effect to a larger extent than the current framework. The objective of this paper has been to compare results from prior analysis, especially regarding how the level of sophistication affects the degree of disposition effect. Results from different studies do not always match, and this paper will investigate this matter and provide possible explanations to this lack of consistency. The prior returns are normally neglected in analysis of the disposition effect, and the paper claim that prior returns has an explanatory value in understanding the level of disposition effect investors are prone to, both empirically and theoretically. When news about a security is released, the security prices do not always change as much as the news should imply. Disposition investor will sell securities that are experiencing positive news and create an excess supply, hence making the security prices lower than it should be. If the news is negative the disposition investors will not sell the security, holding the demand higher than it should be related to the news. This is one of the implications of the disposition effect among investors in the financial market. The disposition effect is reduced when the level of sophistication among investors increases. This is partially because they learn that they are prone to the disposition effect, but also that they have more trades and learn how the financial market works. Prior work has neglected how the prior returns on the investors’ portfolios have been. The paper will discuss how prior returns may affect the level of reluctance to sell losers, hence affecting the disposition effect. Different papers tests for the same effects on similar data, but yield different results and this paper will discuss whether the source of inconsistency in results are prior market movements. The paper first presents a theoretic framework for explaining the disposition effect. Then a overview of the first major empirical and laboratory experiments proving the disposition effect is given, before it further discuss the implications of the disposition effect. In conclusion, the paper will look at possible ways to limit the disposition effect by imposing rules, trading solutions where the investor does not have to realize the paper loss/gain, but rather move the invested amount.