To be a successful active investor, you don’t just need to buy the right stocks at the right time; you also have to decide which stocks to sell and when to sell them. The problem is, investors are prone to what behavioural finance experts call the disposition effect, or the tendency to sell winning investments prematurely to lock in gains and hold on to losing investments too long in the hope of breaking even. And, as new research shows, it’s not just individual investors who sell at the wrong time: professionals fund managers are very much to prone it as well.
A large body of academic evidence demonstrates that individual investors are subject to the “disposition effect”. It has been documented among U.S. retail stock investors, foreign retail investors, homeowners, corporate executives and in experimental settings. Those suffering from this phenomenon, which was initially described by Hersh Shefrin and Meir Statman in their 1985 paper, The Disposition to Sell Winners Too Early and Ride Losers Too Long: Theory and Evidence, tend to sell winning investments prematurely to lock in gains and hold on to losing investments too long in the hope of breaking even.
Standard explanations for the disposition effect — such as tax considerations, portfolio rebalancing and informed trading — have been proposed and dismissed. That leaves explanations that rely on investor preferences, such as prospect theory. Prospect theory implies a willingness to maintain a risky position after a loss and to liquidate a risky position after a gain. It also requires that investors derive utility as a function of gains and losses rather than the absolute level of consumption. Other behavioural explanations include (1) mental accounting (how individuals classify personal funds differently and are therefore prone to irrational decision-making in their spending and investment behaviour), (2) pride seeking and regret aversion, and (3) lacking self-control.
As Toby Moskowitz explained in his 2010 AQR working paper, Explanations for the Momentum Premium, the disposition effect “creates an artificial headwind: when good news is announced, the price of an asset does not immediately rise to its value due to premature selling or lack of buying. Similarly, when bad news is announced, the price falls less because investors are reluctant to sell.” The disposition effect therefore creates predictability in stock returns and thus provides an explanation for the momentum premium.
Additional research into the disposition effect, including a 2012 study by Itzhak Ben-David and David Hirshleifer, Are Investors Really Reluctant to Realize Their Losses? Trading Responses to Past Returns and the Disposition Effect, found that investors sell more when they have larger gains and losses. Stocks with both larger unrealised gains and larger unrealised losses (in absolute value) will thus experience higher selling pressure. This temporarily pushes down current prices and leads to higher subsequent returns when future prices revert to their fundamental values. They also found that the average propensity to sell following a gain is higher than the average propensity to sell following a loss.
Li An, Joseph Engelberg, Matthew Henriksson, Baolian Wang and Jared Williams contribute to the research on the disposition effect with their January 2018 study, The Portfolio-Driven Disposition Effect, in which they sought to determine whether the disposition effect operates at the individual asset level or at the portfolio level. They found:
- There is no disposition effect for a stock if the remaining portfolio is up. However, if the remaining portfolio is down, a stock with a gain is more than twice as likely to be liquidated than a stock with a loss. (Note that, at least for taxable accounts, this is the opposite of what efficient tax management requires, which is the harvesting of losses). The results were significant at well below the 1 percent level of statistical significance (t-stats were in the 20s).
- The authors reached the same results when they considered proxies for investor sophistication, such as professional jobs or high income.
An, Engelberg, Henriksson, Wang and Williams concluded that the most likely explanation for the effect “is that investors derive utility from both paper gains and realized gains and that they take utility by realising gains when they have disutility from unrealised losses.” The authors added: “When their portfolio has paper losses, they compensate by realising gains.” They explained: “When an investor’s overall portfolio is down, the investor will receive a lot of negative utility from the paper losses, so she should be especially likely to seek a burst of positive utility from realising a paper gain to offset some of the negative utility she has received due to the poor performance of her portfolio. This could explain why we find such a strong disposition effect when an investor’s portfolio is down.”
Another interesting finding was that when a stock is at a gain but the portfolio is at a loss, upon realising the gain, investors are most likely to keep the proceeds in cash — it is important to investors that the gain “stay” realized.
The bottom line is that the disposition effect entails adverse consequences for investors’ investment performance. For example, in his 1998 study, Are Investors Reluctant to Realize Their Losses?, Terrance Odean found that the stocks investors sold too quickly as a result of the disposition effect continued to outperform over the subsequent periods, while the losing assets they held on to for too long remained underperformers.
Li An and Bronson Argyle contribute to the behavioural finance literature with their study Overselling Winners and Losers: How Mutual Fund Managers’ Trading Behavior Affects Asset Prices published in the September 2021 issue of the Journal of Financial Markets, in which they examined the selling schedule of mutual fund managers in response to unrealised profits. Their data sample covered the period 1980-2018. Following is a summary of their findings:
- Given an unrealised gain and loss of the same magnitude, mutual fund managers are 1.8 times as likely to sell the gain as to sell the loss.
- Larger magnitudes in both unrealised gains and losses are associated with more selling.
- Consistent with findings on retail investors, managers’ selling response to unrealised profit weakens as the holding time becomes longer.
- U.S. equity mutual fund managers, like supposedly less sophisticated retail investors, tend to sell both their big winners and big losers — the selling pressure pushes down current prices for non-fundamental reasons and thus leads to higher future returns.
- Stocks with large unrealised gains and losses outperform in the next month, and the price effect is both economically and statistically significant — a 10 percentage point increase in the aggregate unrealised gains (losses) for a stock predicts a 9 (5) basis points increase in the next month’s returns. A long-short portfolio strategy based on this effect produced a monthly alpha of approximately 0.5%, with a Sharpe ratio of 1.2.
- Aggregating across funds, securities for which investors have large unrealised gains and losses outperform in the subsequent month.
- Funds with larger turnover, shorter holding period and higher expense ratios are significantly more likely to manifest this trading pattern, and unrealised profits from such funds have stronger return predictability. This tendency was not stronger among funds whose managers graduated from institutions with higher average SAT scores, consistent with this being a biased behaviour.
- The price effect of the disposition effect is absent in the largest firms.
- Their findings were robust to several alternative measures.
Their findings led An and Argyle to conclude: “Mutual fund managers, like individual retail investors, exhibit a V-shaped disposition effect — they are more likely to sell both their big winners and losers. Aggregated across fund managers, this behaviour has an impact on equilibrium prices.
“The subset of funds with higher turnover, shorter holding period, and higher expense ratios are more likely to exhibit the V-shaped disposition effect, and paper gains and losses aggregated across these subsets of funds have stronger return predictability.
“Taken together, this evidence [provides] insight on the pattern, the pricing implications, and the underlying mechanism of the disposition effect. Our results closely tie observed price variation to investors’ behaviour and suggest that seemingly biased trading tendencies can aggregate to predictably affect equilibrium prices.”
The well-documented disposition effect not only provides us with explanations for behavioural-based anomalies, such as momentum, but also with an opportunity to better understand how our behaviours (including those of professional fund managers) can negatively impact our results.
We cannot learn from our behavioural mistakes unless we are aware of them. However, once we become aware of our biases, we can take actions to minimise the effect by setting investment goals and establishing rules (such as when to harvest losses and when to rebalance). Having a written and signed investment plan, including a rebalancing table and defined goals, can help you avoid emotion-driven mistakes that lead to poor outcomes. Do you have such a plan?
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LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.
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