The (Sweet) Disposition Effect

The (Sweet) Disposition Effect - thanks Temper Trap - is a behavioural finance anomaly discovered by two proper smart Canadian Economists, Hersh Shefrin and Meir Statman, back in the 80s.

I, for one, am fascinated by research carried out on behavioural finance. Because, human behaviour and money, are basically the two things I spend most my time studying and the two areas of expertise on which Financial Planners, like Jo and I, hang our hats.

The Disposition Effect relates to the tendency of investors to sell assets or investments that have increased in value, whilst keeping their assets that have actually dropped in value.

Now, I have to stress that this is more aligned to the behavioural patterns of those who trade individual stocks or run their own investment portfolios, rather than the likes of us here at Eelah or our many advised clients, but it makes for interesting reading nonetheless.

Shefrin and Statman’s studies ascertained that "people dislike incurring losses much more than they enjoy making gains, and people are willing to gamble in the domain of losses." Therefore, the research shows that more people will want to hold stocks that have lost value, whilst being keen to get rid of stocks that are at a gain. This was coined as the Disposition Effect.

Another finance professor, Nicholas Barberis, has noted in relation to the Disposition Effect, “that stocks that have done well over the past six months tend to keep doing well over the next six months; and that stocks that have done poorly over the past six months tend to keep doing poorly over the next six months.” This being the case, the rational thing to do would be “to hold on to stocks that have recently risen in value; and to sell stocks that have recently fallen in value. But individual investors tend to do exactly the opposite.”

So, if based on evidence and rationality, it doesn’t make sense to hold on to losers and sell winners, why do so many of us do it? The famous Daniel Kahneman, author of Thinking, Fast & Slow (a book I recommend everyone reads) gave his explanation to the Disposition Effect by stating that, "losses have more emotional impact than an equivalent amount of gains".

What this means is that, if a normal human is presented with two equal choices with the same guaranteed outcome, BUT one is described as having a “potential gain” and the other is described as having a “possible loss”, then normal Mr Human would usually opt for the former ‘gain’ choice, even though both would yield the exact same financial end result.

For example, even though the net result of receiving £100 would be the same as gaining £200 and then losing half of it, us super-irrational humans are far more likely to take a more favourable view of the former scenario, despite both end results being identical. Nuts, ain't we?

How do you avoid this happening? Well, the first step has already been made, cos I am bringing it to the table right now. Knowledge is power and all that.

The second way the disposition effect can be avoided, or at least minimised, is by means of a mental approach called "hedonic framing". In simple terms, this framing encourages investors to consider their higher-level portfolio returns as an overall loss or gain, rather than concentrating on the performance of the fund’s smaller, individual components. But, fundamentally, to have a diverse investment portfolio that is held for the long-term and selected to progress towards a specific investment goal rather than a generic investment.

Interesting stuff. There are loads of behavioural finance theories out there that we can tap into to help shape the way we think and act. I’ll send more out in future blogs.

 

Alfie Mullan, March 2019

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