29 - The Disposition Effect: Trading Behavior and Pricing

Abstract

Investor trading behavior is driven by a combination of preferences and beliefs. Behavioral phenomena predispose investors to sell their winners more frequently than their losers. Representativeness leads individual investors to be trend followers predicting continuation. This chapter describes the main empirical work that documents the disposition effect and describes how the disposition effect causes momentum in security markets. Although there are other explanations for the momentum effect, such as underreaction, the disposition effect alone appears to address why momentum tends to reverse itself at the turn-of-the-year. A series of psychological phenomena that present data consistent with the effect and that propose some testable hypotheses is also explained. The disposition effect is now one of the most, if not the most, studied behavioral patterns in finance. A literature on the disposition effect has developed to test the hypotheses and extend the focus of discussion from investor behavior to pricing and to trading volume. The present chapter surveys the evidence pertaining to the disposition effect. The disposition effect pertains to the combination of preferences and beliefs. Conditional on beliefs, the disposition effect indicates that behavioral preferences predispose investors to sell winners earlier and ride losers longer than occurs when preferences are neoclassical. To be sure, a strong belief in return reversals can also induce investors to sell winners quickly but delay selling losers.