Are Investors Reluctant to Realize Their Losses? – Terrance Odean
Introduction
Odean test the Disposition effect
= The tendency of investors to hold losing investments too long and sell winning investments
too soon.
- Investors demonstrate a strong preference for realizing winners rather than losers.
Their behavior does not appear to be motivated by a desire to rebalance portfolios, or
to avoid higher trading costs of low priced stocks.
- For taxable investments, it is suboptimal and leads to lower after-tax return. Tax-
motivated is most evident in December.
To test the Disposition effect, Odean obtained trading records from 1897 through 1993 for
10.000 accounts at a large discount brokerage house.
Results
- Overall, investors realize their gains more readily than their losses.
- Many investors engage in tax-motivated selling, especially in December.
Alternative explanations for why investors might realize their profitable investments while
retaining their losing investments:
- Investors may rationally or irrationally believe that their current losers will in the
future outperform their current winners.
- They may sell winners to rebalance their portfolios.
- They may refrain from selling losers due the higher transactions costs of trading at
lower prices.
The disposition effect is still active when the data are controlled for rebalancing a for share
price.
Prospect Theory
The disposition effect is one implication of the prospect theory to investments.
- Prospect theory = When faced with choices involving simple 2 and 3 outcome
lotteries, people behave as if maximizing an S-shaped value function.
,This value function is similar to a standard utility function except that it is defined on gains
and losses rather than on levels of wealth.
- The function is concave on gains
- The function is convex on losses
It is also steeper for losses than for gains implies that people are risk-averse.
Critical to this value function is the reference point from which gains and losses are measured.
- Status quo is the reference point. Throughout this study, investors’ reference points are
assumed to be their purchase prices.
An alternative Behavioral Theory
Investors might choose to hold their losers and sell their winners not because they are
reluctant to realize losses but because they believe that today’s losers will soon outperform
today’s winners.
If future expected returns for the losers are greater than those for the winners, the investors’
belief would be justified and rational.
- If, however, future expected returns for losers are not greater than those for winners,
but investors continue to believe they are despite persistent evidence to the contrary,
this belief would be irrational.
Taxes
Investors’ reluctance to realize losses is in conflict with optimal tax-loss selling for taxable
investments. For tax purpose investors should postpone taxable gains by continuing to hold
their profitable investments. They should capture tax losses by selling their losing
investments.
Investors choose to sell their losers in December as a self-control measure.
- The reason that investors are reluctant to sell for a loss but recognize the tax benefits
of doing so.
- The end of the year is the deadline for realizing these losses.
Previous studies
Previous research offers some support for the hypothesis that investors sell winners more
readily than losers.
Investors may be behaviorally motivated to hold losers and sell winners, they may have value
functions like those described in prospect theory or they may incorrectly expect mean-
reverting prices.
There also are rational reasons why investors may choose to hold their losers and sell their
winners:
1. Investors who do not hold the market portfolio may respond to large price increases by
selling some of the appreciated stock to restore diversification to their portfolios.
2. Investors who purchase stocks on favorable information may sell if the price goes up,
believing that price now reflects this information and may continue to hold if the price
goes down, they believe that their information is not yet incorporated into price.
3. Because trading costs tend to be higher for lower priced stocks and because losing
investments are more likely to be lower priced than winning investments, investors
may refrain from selling losers simply to avoid the higher trading costs of low-priced
stocks.
, Data
The data for this study are provided by a nationwide discount brokerage house. The data do
not distinguish different account types; therefore, it is not possible to separate taxable
accounts from tax-free accounts.
The focus is to test the Disposition effect, this is done by analyzing the rates at which
investors realize gains and losses relative to their opportunities to do so.
Empirical Study
Methodology
This study tests whether investors sell their winners too soon and hold losers to long.
It also investigates tax-motivated trading in December.
To determine whether investors sell winners more readily than losers, it is not sufficient to
look at the number of securities sold for gains versus number sold for losses.
To test whether investors are disposed to selling winners and holing losers, we must look at
the frequency with which they sell winners and losers relative to their opportunities to sell
each.
Each day that a sale takes place in a portfolio of 2 or more stocks, I compare the selling price
of each stock sold to tis average purchase price to determine whether that stock is sold for a
gain or a loss.
Verder lezen.
2 ratios:
A large difference in the proportion of gains realized (PGR) and the proportion of losses
realized (PLR) indicates that investors are more willing to realize their gains or losses.
Some possible choices of a reference point for stocks are:
- The average purchase price
- The highest purchase price
- The first purchase price
- Most recent purchase price
Although investors may not consider commissions when they remember what they paid for a
stock, commissions do affect capital gains and losses.
And because the normative standard to which the disposition effect is being contrasted is
optimal tax-motivated selling, commissions are added to the purchase price and deducted
from the sales price in this study.
Dividends are not included when determining which sales are profitable cause they do not
affect capital gains and losses for tax purpose,
, There are 2 hypotheses to be tested. First, investors tend to sell their winners and hold their
losers.
H0: PGR is less or equal to PLR
Second hypothesis is that in December investors are more willing to sell losers and less
willing to sell winners than during the rest of the year.
H0: PLR-PGR in December is less or equal to PLR-PGR.
Results
We see that for the entire year investors do sell a higher proportion of their winners than of
their losers.
For both hypothesis 1 and 2 the null hypothesis can be rejected.
The previous test, weights each account by the number of realized and paper gains and losses
in that account.
This alternative test weights each account equally, which means we ignore the fact that
accounts with more transactions provide more accurate estimates of their actual PGR and
PLR.
- In other words: by treating each account the same, we assume that the observed
account PGRs and PLRs are homoscedastic when they are clearly heteroskedastic.
It should be noted that the PGR and the PLR measures are dependent on the average size of
the portfolios from which they are calculated
When PGR and PLR are calculated, the accounts with more trades weigh more heavily than
those with fewer trades. In the alternative specification described in the last paragraph all
accounts weighted equally.
- For this reason, PGR and PLR are both larger in the alternative specification than in
our table 1.
- One reason investors might choose to sell winners rather than losers is that they
anticipate a change in the tax law under which capital gains rates will rise.
It is possible therefore that the rate at which winners are being realized relative to losers is
lower in the investors total portfolio than in the partial reconstructed portfolio.
- Another reason investors might sell winners and hold losers is that they expect the
losers to outperform the winners in the future.
o An investor who buys a stock because of favorable information may sell that
stock when it goes up because she believes her information is now reflected in
the price
o On the other hand, if the stock goes down she may continue to hold it,
believing that the market has not yet come to appreciate her information.
- Investors could also choose to sell winners and hold losers simply because they
believe the prices mean revert.
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