Assume that you purchase a stock of A Ltd. for Rs. 2,000. Further, assume that the stock market falls and the price of your stock plunges to Rs. 1,500. Don’t feel bad, it is just an assumption. Now, since you have already lost Rs. 500, and there is a 50-50 probability that the stock may gain or fall by Rs. 500 in price again, would you rather sell the stock now and suffer a loss of Rs. 500 or would retain the stock for some time and at least try to break even despite the risk that your loss can double? With the sane-glasses on, trying to break even deserves a shot, right? Even if you are unable to make a profit, there is no harm in trying to cover the loss. But what seems to be sane, apparently isn’t. After all, there is an equal probability of losing another Rs. 500 and hence, deepening the loss. Interestingly, this also applies in the case of profits. The investors tend to sell the winning stocks, that is, whose prices are on a rise, early, to book their profits as soon as possible even when they think that the stock has the potential to grow. This is called the Disposition Effect.
Framed at Santa Clara University, US, by professors Hersh Shefrin and Meir Statman, the disposition stems from the Prospect Theory by Israeli psychologists Daniel Kahneman and Amos Tversky which involves making choices by first comparing and then evaluating each option based on their value and weight. This anomaly in behavioral finance, Disposition Effect, works on the principle that a “regret aversive nature” makes people sell profit-making assets early while holding on to their losses in the belief that it will bounce back eventually. Besides, people tend to avoid regret since they feel ashamed in acknowledging and admitting an error in their judgment and are always up to gamble and probably, to deepen their losses. While in cases of profits, just to prove that they have made the right decision and to seek pride, people have a propensity of booking their profits early and in turn, probably lose hands-on higher profits. Losing, it seems, is a graver emotional phenomenon than gaining.
The resistance to realize the losses end in getting penalized by the stock market. Reports suggest that it is 1.7 times more probable that people sell their winning stock and retain a losing one than doing the exact opposite. Investors should be aware of this effect because studies found that the winners that are sold generally outperform the stocks that are retained by the investors, thus leaving them better off than they could ever be by benefitting from the stock momentum.
There has been a lot of pieces of evidence to prove the disposition effect. Like the people who chose to retain the stocks of Satyam Computer Services (now, Mahindra Satyam) despite its controversial announcement of taking over Maytas Infras and Maytas Properties in December 2008 had to suffer a bigger loss in the form of its price plunging to around 24% of its value within a day. But one can win over the Disposition effect using the Precommitment Technique.
It involves setting a particular time frame for selling the winners in the stock market. In other words, this implies pre-determining the investment horizon whenever a profit-making asset is on the plate and consider selling it only once the period is over. On the other hand, to prevent the multiplication of losses, this technique involves setting a mandate for realizing losses according to one’s risk appetite, say a 10% fall or whatever is deemed suitable. Once the price plunges deeper, it is a clear indication to abandon the gamble.
A mental solution to the problem also exists, the Hedonic Framing. It revolves around the idea that the investor may fool his/her prejudices by thinking of small losses as a single, big loss and the exact opposite in case of profits, that is, splitting up of a single, big profit as multiple small profits. It can hence be rightly said that it is at the disposition of the Disposition Effect that leads the loss- aversion tendency of humans to even bigger losses.