Selling Winners or Losers: Two-Stage Decision Making and the Disposition Effect in Stock Trading

Abstract

The disposition effect is regarded as a property of an individual stock: If an investor has made a loss on a stock, he or she is less likely to sell it, whereas if an investor has made a gain on a stock, he or she is more likely to sell it. This means that the more stocks in a portfolio are in gain, the greater the probability that the stock sold will be in gain. But we show that the disposition effect is, in the large part, a gain-loss domain level decision, where investors first decide whether to sell a stock in the domain of gains or losses, and only then choose a stock to sell from within their chosen domain. The signature of this two-stage model is that the probability that the stock sold will be in gain is constant across portfolios with different numbers of stocks in gain and in loss. We see this pattern very clearly in two independent stockbroking datasets, one from the US investors from 1990s and another from UK investors from 2010s. We also see the pattern in a stockbroking experiment where we randomly vary the number of gains and losses in a portfolio. We conclude that sell decisions are taken at the gain-loss domain level, not just at the individual-stock level.