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Disposition Effect

CHAPTER ONE: Introduction

As a multidisciplinary field which is an intersection of psychology and economics, the behavioural finance core idea is that our emotions, preferences, and at times, poor judgment, influence our financial decisions. Many different anomalies can only be explained through the scope of behavioural finance, and one of that is related to explaining trading volume in equities.

This anomaly, first coined in 1985 by Sherfin and Statman through their paper “The disposition to sell winners too early and ride losers too long: theory and evidence.” Is called the disposition effect. The disposition effect is related to how investors have a tendency where they are more inclined to sell stocks that are increasing in value to ensure their gains while acting somewhat risk-averse towards stocks that are decreasing in value by retaining those stocks in their portfolio (Shefrin and Statman, 1985).

CHAPTER TWO: LITERATURE ANALYSIS

2.1 The Mechanics of Disposition Effect

To see how the disposition effect works, we will take a look at two different scenarios. If an investor is buying an investment STOCK1 with the price of A and for some reason, the value of the stock falls by B amount of value. This would make the price of that stock as A-B. We can commonly refer to this kind of stock as the ‘loser’ stock or ‘winner’ stock if the value of stock rise by B amount of value.

STOCK1=A



, the initial price of the stock

STOCK1=A-B



, the price of the stock after the value falls by B amount

STOCK1=A+B



, the price of the stock after the value rise by B amount

With this condition, now the investor has two option on whether selling or holding it. The stock itself has an equal chance of stock to either return to its purchase price of A or to fall again by B amount to the price of A-B-B or A-2B. Now this stock is worth A-B if sold and either A or A-2B if held. If the Investor is using A as their reference point, this will make the investor face a choice of certain loss with a value of B or taking a gamble with the value of A to break even or even more significant loss with the value of 2B.

STOCK1=A-B



, if the investor decided to sell the stock

STOCK1=A or
STOCK1=A-2B




, if the investor decided to hold the stock

The same effect of disposition effect can also be seen in ‘winner stock’, the stock would worth to amount of A + B if sold and either A or A+B if held.

STOCK1=A+B



, if the investor decided to sell the stock

STOCK1=A or
STOCK1=A+2B




, if the investor decided to hold the stock

With disposition effect in place, with the ‘loser’ stock the investors will try to keep the stock because the pain of enquiring more loss in value of 2B is felt better the pleasure of managing to recover the value of purchase price. While for the ‘winner’ stock, the investor will try to let go of the stock to lock in their gain (Weber and Camerer, 1998).

By looking at those two different scenarios, we can see that the disposition effect caused the investor to act on their investment decision based on the view of the potential estimation of losses and gains as opposed to the many possible results that might be more beneficial to their investment.

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