ANALYSIS OF THE DISPOSITION EFFECT: ASYMMETRY AND PREDICTION ACCURACY

Abstract

The disposition effect describes investors’ common tendency of selling a winning investment too soon and holding on to losing investments too long. We analyze the disposition effect in a prediction market for economic indices. We show that the effect for individual traders as well as on an aggregated level. Furthermore we find a significant asymmetry of the disposition effect. The effect can almost exclusively be attributed to the percentage of gains realized (PGR). Additionally we link the aggregated disposition effect and market efficiency. A common hypothesis of the behavioral finance literature is that if participants make systematically biased decisions, market efficiency will suffer. Our setup is well-suited to studying the behavioral aspects of decision making because, in contrast to financial markets (i) the value of shares in our market is ultimately known and (ii) we can measure the participants’ behavioral biases (i.e the disposition effect). Against intuition we find no correlation between the disposition effect and prediction accuracy - a proxy for market efficiency.