Not in my mind: The disposition effect is in the eyes of the beholder

Abstract

We propose an extension to the concept of the disposition effect by allowing the use of alternative reference points. While the traditional definition is based on classifying stocks as winners and losers solely based on the purchase price, we incorporate stock prices closer to sell date into the construction of the reference point. We study these concepts in a large individual trader dataset. Using the average of the last five trading day prices as reference point, we find a reduction of the disposition effect by 71%. It decreases further for investors who trade more and whose trading episodes are shorter. This opens up the possibility that the disposition effect, viewed from a psychological perspective, might be a weaker phenomenon than the traditional calculations suggest.

Keywords: Disposition effect, Reference point, Stock market, Behavioural bias, Individual investors

JEL Classification: C55, D90, G40