The study of how human instinct impacts on investment decisions is hotly debated and sometimes controversial. But even Ben Graham, the father of value investing, was aware of the potential for investors to err. He famously warned that “the investor's chief problem - and even his worst enemy - is likely to be himself.”
One of the best known behavioural trap-doors is to hang onto losing investments for too long and sell winning positions too soon. It’s a phenomenon known as the Disposition Effect. For years, researchers have warned that investors can damage returns by cutting winners and riding losers. Often, this warning has been pitched in the direction of relatively unsophisticated retail investors. But new research suggests that the same behavioural flaw exists in some of the market’s smartest and best informed traders - Short Sellers.
It serves as a reminder that the risk of succumbing to selling the wrong positions is something every investor needs to be aware of. So here’s a review of how things can go wrong and why smart investors are susceptible too.
Why we sell the wrong shares
If you were looking at a map of behavioural finance, you’d arrive at the Disposition Effect directly from two other places: prospect theory and mental accounting. These are theories about how humans make choices between risky prospects and how they categorise them based on different outcomes.
In the context of investing, these theories claim that investors treat the probability of a loss differently to that of a gain. With the Disposition Effect, what this means is that investors irrationally sell winners and hold losers even though it often makes no economic sense.
Some of the best research into the consequences of all this was done by Terrance Odean, who waded through 10,000 accounts held at an American discount broker between 1987 and 1993. He found a clear tendency for investors to sell winning positions over losing positions. Moreover there was no good reason for it - there was no evidence that these investors were deliberately rebalancing their portfolios. On average, after one year, the losing stock, that was held, fell by 1.0% against the market. While the winning stock, that was sold, actually gained 2.4% above the market.
Momentum rides on the Disposition Effect
Clearly, Odean’s findings show that the Disposition Effect can damage performance - but not everyone loses. Readers…