Some Gains Are Riskier Than Others: Volatility Changes, Belief Revisions, and the Disposition Effect

Abstract

I examine whether investors revise their beliefs about a stock's risk due to an increase in the stock's volatility. This revision makes loss-averse investors more willing to sell a riskier stock with a paper gain as the likelihood of having to sell it at a loss later increases. An analysis of a large Finnish dataset on the holdings and trades of individual investors yields empirical support for this prediction: a one standard deviation increase in volatility is associated with an 11% increase in the disposition effect. The effect primarily emerges from investors' increased propensity to sell stocks with small paper gains.

Keywords: Disposition Effect; Probability of Losses; Volatility Change; Belief Revision

JEL Classification: G11, G41