Investment Experience can help you Decrease the Disposition Effect but it is not a Guarantee
The Bachlor thesis of Aron Friedman and Etiosa Richmore investigates a decision-making bias that is particularly relevant in financial market trading: the so-called “disposition effect”. In contrast to some other studies, they were unable to find significant differences between experienced and inexperienced financial traders—both were equally prone to fall prey to the disposition effect. The thesis makes an important contribution to economic decision-making literature.
The origin of the Disposition Effect
“Cut your losses short and let your winners ride” is a well-known trading rule which has been circulating the stock market for decades. A piece of advice simple in its form but inherently psychologically challenging to follow when hard-earned money is at stake. This famous trading rule led to the idea behind the thesis that was to examine the Disposition Effect, which is a well-known anomaly in the area of behavioral finance. The theory was defined by Shefrin and Statman in 1985 and can be characterized by investors being more likely to “sell winners too early and ride losers for too long”. We decided to study the Disposition Effect and investigate if it could be found in Sweden and if investment experience could play a part in how apparent the effect would be.
The Experiment Performed
The experiment was conducted by first recruiting 73 participants that were mostly Swedish students or faculty members and letting said participants play a stock simulation game. The participants had the ability to buy three stocks, named A, B, and C. The game was played for 36 rounds and each round there was a choice to either sell, buy or do nothing and proceed with a stock. These choices were later on sent to the authors for analysis. By looking at how frequently the participants sold or bought stocks that had risen or fallen relative to the initial price, the Proportion of Gains Realized (PGR) and Proportion of Losses Realized (PLR) was calculated. The PGR and PLR were then used to see if the participants sold “winning” stocks more frequently compared to “losing” stocks and thus exhibiting the Disposition Effect. Furthermore, experience was then measured by letting participants determine how experienced they were in a survey after the experiment. By doing so, we could then divide the groups into an experienced group and an inexperienced group in order to compare the results between them.
The results displayed that the participants exhibited a positive Disposition Effect so they were likely to hold onto losing stocks and sell their winners too early. In this area the results were strong. The results we received were in line with previous research in this regard. However, it was surprising that both inexperienced and experienced investors were falling prey to the Disposition Effect; the statistical effect did not differ significantly between the subgroups.
The experiment was set up in a way that if a stock increased in value it was more likely to increase and if it decreased it was more likely to decrease in future, which was clearly communicated to the participants. Despite the information, there we still found a pronounced Disposition Effect. This can be compared to the financial market today where it happens frequently that investors dispose their stocks after having accumulated some profit to move on to another stock, although the better option would be to hold on to the stock that has been increasing in value historically.
The Disposition Effect has been a topic since 1985 and to this day there is no clear answer to the reason behind it or what could dampen the effect. However, the aspect of investment experience could definitely play a part in this topic. Nonetheless, it is an interesting topic to look into further and we are looking forward to reading continuous studies in this area to enlighten us further. What do you think is reason behind the Disposition Effect?
Aron Frieman: https://www.linkedin.com/in/aron-frieman-1b86808b/
Etiosa Richmore: www.linkedin.com/in/etiosarichmore