Once upon a time most economists and some investors thought people behaved rationally when it came to their money. Economic theory assumed investors, on average, would make good, even optimal decisions in terms of maximizing their wealth: Real money was at stake, so people would do the thing that earned them the most.
Psychologists who study how people make decisions were under no such illusions. They knew our decisions are driven by irrational impulses, gut instincts, and the way our brains process information, rather than the cold rationality embedded in economic models. Finally, researchers stopped arguing about theory and studied how investors actually make decisions. They found that investors behave the way psychologists predicted, not the way economists predicted. Behavioral economics was born.
Doing everything wrong
The most clear and startling finding came from Terry Odean, an economist at Berkeley. Odean's research is now one of the classics of the behavioral finance literature, even though arguably the field is too young to have classics. Odean studied the stock-selection decisions of individual investors. He found we do everything wrong: We trade too often for no economic gain. We are undiversified, holding only a few stocks that get our attention.
The details get even more interesting. We easily sell off stocks that have done well, but we have trouble letting go of stocks that have performed badly, holding onto them in the hope they will come back. This is ruinous on two levels. By selling winners and holding onto losers, we are setting ourselves up for a tax hit, because we face taxes on stocks that have appreciated. Because stock prices show momentum, the stocks we have sold tend to keep rising. And the stocks we hold tend to keep falling.
The disposition effect in stock trading, once a heretical idea, is now mainstream.
Our trading patterns make no economic sense given these results, but they make a lot of psychological sense. We feel we should at least get what we paid for a stock, even if the stock market has no interest in our feelings. The behavioral economists Meir Statman and Hersh Shefrin called this the "disposition effect," as shorthand for our "predisposition to get-even-itis." As a result, we have trouble letting go of stocks that are worth less than we paid for them.
Amplifying this impulse is the different way we experience gains and losses identified by the psychologists who pioneered behavioral economics. Losses are more painful than gains. Moreover, we are willing to gamble on the downside, to make a certain loss less certain. By holding onto our losers, we are hoping they will go up. For our stocks that are winners, we aren't compelled to gamble and want to lock in our gains. And as a result, we sell our winners and hold onto our losers. Psychologically, we are satisfied, only to be punished by the stock market for our actions.
Odean was familiar with these behavioral theories and predictions. His personal history in many ways anticipated his nonconventional research agenda. Odean was a college dropout who had worked as a New York City cab driver, among other jobs, before returning to get his undergraduate degree at Berkeley at age 37.
As a "mature student," he met psychologist Daniel Kahneman, the future Nobel laureate, then in the process of refining his work on decision making. Kahneman suggested Odean continue on in graduate school in economics rather than in psychology. Odean analyzed real stock-trading data for evidence of psychological factors at work, which no one had bothered to do before. He discovered how precisely trades followed the disposition effect, with investors trying to get even in terms of what they paid for a stock.
Odean remembers the reactions to his discovery at the time, way back in 1997, which is not exactly light-years ago, but a very different economic environment from today. The tech bubble was just heating up. "The standard response from professors was, 'Personally I think this is interesting, but my colleagues won't be as open-minded as I am,'" says Odean. The group dynamics at work interested him as a behaviorist. Everyone liked thinking of themselves as open-minded. But at the same time, no one dared risk publicly acknowledging in a group setting the merits of the behaviorist approach.
The news media had no such hesitation. Odean's findings broke out into the press, which is rare for an economics research paper, and Odean did numerous TV appearances (though audiences were surprised to see an economist sporting an earring the size of a class ring). The profession changed its views. The disposition effect in stock trading, once a heretical idea, is now mainstream, and even arguably part of a new orthodoxy. Every financial planner warns against the human tendency to sell our winners and hold onto our losers.
This instinctive error in stock trading might still pose some dangers to investors, but it has greatly diminished in impact. The effect is now widely known, and the age of the day trader is over in any case. Most trading is now done by institutional investors, where the disposition effect is less pronounced. It isn't their money, so they are less emotionally involved.
Capitalizing on the effect
Being aware of the disposition effect is primarily a defensive strategy. (If you are trading stocks, next time you are holding onto a losing position, hoping it will come back, ask yourself how realistic this belief is. Also consider the tax consequences of selling.)
However, you can take advantage of the disposition effect exhibited by other investors. This profitable trading is one way to make money off of psychological insights about investor behavior.
Again, central to the strategy is the fact that people don't like to sell things at a loss. This is an immensely strong behavioral bias. The way to make money is to apply this insight to earnings announcements. Suppose a company has surprisingly good earnings. The stock goes up. Investors have no trouble selling off their winners. The market becomes swamped with sellers, so the price doesn't rise immediately.
But let's say the opposite happens. The company has a negative earnings surprise. The stock goes down. Investors are very unlikely to realize their losses. They hold onto the stock, hoping it will come back. As a result, the price of the stock doesn't fall, at least not at first.
What this means is in both cases it takes awhile for the stock price to reflect its new situation. If the stock has gone up, the dumping of shares slows down its price increase. If it goes down, the hoarding of shares slows down its price decrease. In both cases, the stock price eventually reflects its true value but takes awhile to get there, giving you time to move, to buy stocks going up, and to short or sell stocks going down.
For stocks with good news, waiting to sell makes sense.
Though exploiting the disposition effect can be a profitable strategy, there is an additional factor influencing the speed of change, making returns more predictable—and that is knowing the reference point, the price at which someone purchased the stock. The disposition effect always involves a reference point.
If you bought IBM at $1 and it goes up to $20 and then drops to $19, you still view it as a winner. But if it drops to 50 cents, then the get-even-itis effect kicks in, quite intensely. You are now extremely reluctant to sell the stock. If there are many investors like you, the price decline will be severely slowed down. This gives hedge funds more of a profit window, because the market isn't reacting instantaneously. Sophisticated hedge funds now try to identify and sort the purchase price of a stock in order to be able to identify the magnitude of the disposition effect in order to improve returns.
Don't trust your gut
The trading strategy based on the disposition effect and stock price sorting was first identified by Andrea Frazzini, a finance professor at the University of Chicago Business School, who is also well known in the hedge fund world. Frazzini explains: "From my active investor point of view, I like to short stocks with bad news." But even if you aren't shorting these stocks, you should consider selling them, according to Frazzini. It won't generate enormous, market-beating returns but instead may simply be the sensible thing to do. He says, "Stocks with bad earnings announcements keep going down for awhile. Individual investors should just sell them. Waiting can only lose you money."
For stocks with good news, waiting to sell makes sense. The disposition effect means everyone is selling, depressing the rise in price at first, but eventually it reaches fair value. Waiting eventually makes you money.
In other words, do the complete opposite of what your gut impulse tells you, as seen in the disposition effect. Sell your losers, and hold onto your winners.