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Disposition effect

Disposition effect

In the third part of the series on investor psychology, learn why you tend to carry your losses or are blindfolded by small profits.

Suppose you purchase stock X for Rs 1,000, which plunges to Rs 700. There is an equal probability of the stock gaining or falling by Rs 300 in the near future. Assuming there are no taxes or transactional costs, which of the two options would you choose?

A Sell the stock now, thereby losing Rs 300.

B Hold the stock, given that you have a 50-50 chance of losing an additional Rs 300 or breaking even.

The second option is the obvious choice, right? You would at least want to break even, if not make a profit, wouldn't you? But what seems to be a clear pick may not be the right choice. After all, there is an equal chance of losing another Rs 300 and, thus, deepening the loss.

Interestingly, this also works the other way round. Investors have a propensity to sell winning stocks early and book profits when the stocks might have the potential to grow further. It's called the disposition effect.

A regret aversive nature makes you hold on to your losses and sell profit-making assets
This concept was framed by Hersh Shefrin and Meir Statman, professors at Santa Clara University, US, and they used the above question as a test for this psychological pitfall. Their premise has its fundamentals rooted in the prospect theory by Israeli psychologists Daniel Kahneman and Amos Tversky.

The two scientists blame this tendency to deepen losses and lock in early gains on the regret aversive nature of investors. The psychology responsible for holding a losing security is the belief that it will bounce back eventually. Also, people are hesitant to admit an error of judgement and, therefore, are ready to gamble on the downside. The positive counterpart of regret being pride, they are quick to book profits to prove the accuracy of their decisions.

As a result, they end up selling winners and hold on to their losers. They are satisfied psychologically, only to be penalised by the stock market. In a paper, 'Are investors reluctant to realise their losses?' Terrance Odean, a professor at University of California, further explores this behavioural flaw among individuals.

Data collected from 10,000 accounts in a US brokerage between 1987 and 1993 shows that investors are 1.7 times more likely to sell a winning stock than a losing one. Odean also found that the winners that were sold generally beat the market by an average of 2.35 per cent in the following year, while the losing stocks held by investors underperformed by an average of 1.06 per cent.

In a similar behavioural display in India, those who did not dispose of the sliding stocks in Satyam Computer Services (now, Mahindra Satyam) even after its controversial announcement of acquiring Maytas Infra and Maytas Properties in December 2008, suffered a bigger loss. On 7 January 2009, the stock price fell from Rs 179 to Rs 39 in a day's trading.

One can overcome the disposition effect through, what is termed, the precommitment technique. Place your winners within a time frame. This implies that when you come across a profit-making asset, pre-determine your investment horizon and consider selling only after this period.

Likewise, set a mandate for realisation of losses, say a 25 per cent fall. Once the asset crosses this hurdle, that is, you lose more than one-fourth of your investment, you know it's time to get out. Though the mandate can vary according to your risk appetite, a very low margin can be erroneous considering the present volatility, whereas anything more than 25 per cent may be too high a stake.