Dying Out or Dying Hard? Disposition Investors in Stock Markets

Abstract

Prior research documents that many investors disproportionately hold on losing stocks while selling stocks which have gained value. These systematic behavior is labeled the "disposition effect". The phenomenon can be explained by prospect theory's idea that subjects value gains and losses relative to a reference point like the purchase price, and that they are risk-seeking in the domain of possible losses and risk-averse when a certain gain is obtainable. Our experiments were designed to test whether individual-level disposition effects attenuate or survive in a dynamic market setting. We analyze a series of 36 stock markets with 490 subjects. The majority of our investors demonstrate a strong preference for realizing winners (paper gains) rather than losers (paper losses). We adopt different reference points and compare the behavioral patterns across three main trading mechanisms, i.e. rules of price formation. The disposition effect is greatly reduced only within high pressure mechanisms like a dealer market when the last price is assumed as a reference point which is a more market driven (external) benchmark. If disposition investors use the purchase price as a reference point which is a more mental-accounting driven (internal) benchmark they are dying hard in all market settings.

Keywords: Behavioral Finance, Disposition Effect, Prospect Theory, Experimental Asset Markets, Call Markets, Continuous Trading, Dealer Markets

JEL Classification: D44, G12, G14