Are Investors Reluctant to Realize Their Losses? (Digest Summary)

Shefrin and Statman (Journal of Finance, 1985) have called the tendency
of investors to hold losing positions too long and sell winning positions too soon the
disposition effect. For taxable investments, the disposition effect predicts that
investors will behave quite differently from how they would if they paid attention to
tax consequences. The author uses market data to examine whether investors with discount
brokerage accounts sell winners more readily than losers. He also examines tax-motivated
trading in December.

Kahneman and Tversky (Econometrica, 1979) explain that according to
prospect theory, when people are faced with choices involving simple two- or
three-outcome lotteries, they behave as if maximizing an S-shaped value function. This
value function is defined by gains and losses and is steeper for losses than for gains,
which implies that people are generally risk averse. The status quo is taken as the
reference point. In this study, the author views the purchase price as the reference
point for investors.

Investors might choose to hold their losers and sell their winners not because they are
reluctant to realize losses but because they believe that today's losers will soon
outperform today's winners. In experimental settings, Andreassen (Organizational
Behavior and Human Decision Processes, 1988) finds that investors buy and
sell stocks as if they expect short-term mean reversion. Constantinides (Journal
of Financial Economics, 1984) shows that when there are transaction costs,
and no distinction is made between the short-term and long-term tax rates, investors
should gradually increase their tax-loss selling from January to December.

The data for this study are provided by a discount broker. The period covered is January
1987 through December 1993. By going through each account's trading records, the author
sets up for each date a portfolio of securities for which the purchase date and price
are available. Each stock that is in a portfolio at the beginning of a day but is not
sold is considered to be a paper (unrealized) gain or loss (or neither). If the stock's
daily high and low are above its average purchase price, it is counted as a paper gain;
if the daily high and low are below its average purchase price, it is counted as a paper
loss; if its average purchase price lies between the high and the low, neither a gain
nor a loss is counted.

The author's finding that investors are reluctant to sell their losers and prefer to sell
winners is not influenced by the inclusion or exclusion of commissions or dividends.
Through its impact on supply, the disposition effect may also contribute to market
stability near prices at which substantial trading has previously taken place. Odean
finds that individual investors demonstrate a significant preference for selling winners
and holding losers, except in December when tax-motivated selling prevails. This
investor behavior does not appear to be influenced by a desire to reconfigure portfolios
or by a reluctance to bear the higher trading costs of low-priced stocks. Subsequent
portfolio performance does not justify this behavior either. In fact, this aberrant
behavior by investors leads to lower returns, particularly for taxable accounts.