1. "I never attempt to make money on the stock market. I buy on the
assumption that they could close the market the next day and not reopen it
for five years." - Warren Buffett.

5. Disposition effect
• The tendency to sell winners and hold losers is
called the Disposition Effect. It is one of the
psychological biases plaguing the investors.
• Biases are human tendencies that lead us to
follow a particular quasi-logical path, or form a
certain perspective based on predetermined
mental notions and beliefs.
• When investors act on a bias, they do not explore
the full issue and can be ignorant to evidence that
contradicts their initial opinions. Avoiding cognitive
biases allows investors to reach impartial decision
based solely on available data.

6. Terence Odean is a
professor
of banking and finance at
the Haas School of
Business, University of
California, Berkeley

7. His Study
• Data Collected for Year 1987-1993.
• Trading transaction records for 10,000 discount
Brokerage Account with 100,000 transactions.
• Documented the tendency of individual investors
to sell winners and hold on to losers.
• Used Purchase price as the reference
• Paper gain: any sales that could have been at a
gain
• Focus was on frequency of the winner/loser
sales relative to the opportunities for the
winner/loser sales.

8. • Proportion of Gains Realised = realized
Gain/(realized gain + Paper gain)
• Proportion of Losses Realised =realised
loss/(realised loss + paper loss)

9. Findings
• Since PGR>PLR for entire year, clear tendency to
sell winners than the looser.
• (for tax reasons the investors should prefer to sell
losers and not winner. An investor with positive tax
rate should put of realizing gains on winners
because of the tax liability generated, but should
recognize losses sooner in order to reduce current
tax liability.)
• The second column shows the disposition effect
as, inthe month of december, investors most
likely to invest for tax reasons: therefore greater
tendency to sell loosers than the winners. Its in the
11 months , the disposition effect dominates.

10. Conclusion
• Odean reveals various possibilities related to
rationality.
• We know that if our portfolio has more of losers,
we have to take more positions relative to the
winners for the desired portfolio allocation.
However, in this study it did not have much of
effect.
• Investors anticipate that losers will one day out
perform the winners.- long term reversal
tendency
• Unfortunately investors have their timing wrong.
They are selling medium term winners and holding
on to medium term losers. This is exactly
opposite of what they should have done.

11. 'House Money Effect'
The tendency for investors to take more and greater risks when
investing with profits. The house money effect gets its name from
the casino phrase "playing with the house's money." The house
money effect was first described by Richard H. Thaler and Eric J.
Johnson of the Johnson Graduate School of Management of
Cornell University.
The house money effect forecasts that investors are more prone to
buy higher-risk stocks after a profitable trade. Some believe that the
house money effect is an example of mental accounting, whereby
capital is kept separate from recent profits, leading investors to view
said profits as disposable. As a result, they are more inclined to
take greater risks with the money.

12. Evidence of house money effects
ona large scale
• One recent study by Thierry Post, Martjin
J. Van Assem, guido Balstussen, and
Richard Thaler examined the choices
made on the popular game show “deal or
no deal?”
• The researcher find that contestants’
decisions are influenced by what has
happened before.

13. 'Prospect Theory'
• A theory that people value gains and
losses differently and, as such, will base
decisions on perceived gains rather than
perceived losses. Thus, if a person were
given two equal choices, one expressed in
terms of possible gains and the other in
possible losses, people would choose the
former.

14. Example
One investor was presented with the same mutual fund by two different
financial advisors. The first tells the investor that the mutual fund has
had an average return of 7% over the past five years. The second
advisor tells the investor that the mutual fund has seen above-average
returns in the past 10 years but has been declining in recent years.
According to prospect theory, even though the investor is presented
with the same mutual fund, he or she is more likely to buy the mutual
fund from the first advisor, who expressed the rate of return as an
overall 7% gain, rather a combination of both high returns and losses.

15. IntroductionIntroduction
• For over thirty years individual decisionFor over thirty years individual decision
makers have not behaved in accordancemakers have not behaved in accordance
with the expected utility theorywith the expected utility theory
• The tendency to sell winners too earlyThe tendency to sell winners too early
and ride losers too long is referred to asand ride losers too long is referred to as
the ‘disposition effect’the ‘disposition effect’

16. Disposition EffectDisposition Effect
• The ‘disposition effect’ has four majorThe ‘disposition effect’ has four major
elementselements
1.1. The prospect theoryThe prospect theory
2.2. Mental accountingMental accounting
3.3. Regret aversionRegret aversion
4.4. Self-controlSelf-control

17. Prospect TheoryProspect Theory
• According to the Prospect theory the investorAccording to the Prospect theory the investor
goes through 2 stages of decision makinggoes through 2 stages of decision making
1.1. The ‘editing stage’ frames all choices in termsThe ‘editing stage’ frames all choices in terms
of potential gains and/or losses relative to aof potential gains and/or losses relative to a
fixed reference point.fixed reference point.
2.2. The ‘evaluation stage’ in which the decisionThe ‘evaluation stage’ in which the decision
maker employs an S-shaped valuation functionmaker employs an S-shaped valuation function
(meaning a utility function on the domain of(meaning a utility function on the domain of
gains and/or losses) which is concave in thegains and/or losses) which is concave in the
gains region and convex on the loss region.gains region and convex on the loss region.

18. Prospect TheoryProspect Theory
• Consider an investor who purchased aConsider an investor who purchased a
stock for $50 one month ago and thestock for $50 one month ago and the
stock now is selling at $40stock now is selling at $40
-There are 2 outcomes to this situation--There are 2 outcomes to this situation-
1.1. Sell the stock now and realize a loss of $10Sell the stock now and realize a loss of $10
OROR
2.2. Hold the stock for one more period, with aHold the stock for one more period, with a
50-50 odds between losing an additional $1050-50 odds between losing an additional $10
or “breaking even”or “breaking even”

19. Prospect TheoryProspect Theory
• Since the choice between these two isSince the choice between these two is
associated with the convex portion of theassociated with the convex portion of the
S-shaped value function, prospect theoryS-shaped value function, prospect theory
implies that B will be selected over A.implies that B will be selected over A.
• This seems to apply even if the odds ofThis seems to apply even if the odds of
breaking even were something less thanbreaking even were something less than
50-50.50-50.

20. Mental AccountingMental Accounting
• There areThere are 22 kinds of tax on stock returns.kinds of tax on stock returns.
1.1. Short-term gains (less than a month) is taxedShort-term gains (less than a month) is taxed
like incomelike income
2.2. Long-term gains is taxed lowerLong-term gains is taxed lower
• Lets consider an investor who experienced aLets consider an investor who experienced a
price decline in his stock. Then this investor willprice decline in his stock. Then this investor will
only sell to exploit the difference between shortonly sell to exploit the difference between short
and long term tax.and long term tax.

21. Mental AccountingMental Accounting
• The IRS requires that thirty days pass before aThe IRS requires that thirty days pass before a
stock can be repurchased, if the investor wantsstock can be repurchased, if the investor wants
to get a tax advantage stemming from its sale.to get a tax advantage stemming from its sale.
• Wash sale regulations can be neutralizedWash sale regulations can be neutralized
through a “swap” by replacing a stock sold forthrough a “swap” by replacing a stock sold for
tax purposes with a stock that has identicaltax purposes with a stock that has identical
return distribution.return distribution.
• The main point here is that the swap reduces theThe main point here is that the swap reduces the
investors tax liability leaving him with an equalinvestors tax liability leaving him with an equal
gamble.gamble.

22. Seeking Pride & Avoiding RegretSeeking Pride & Avoiding Regret
• The simple fact is investors mayThe simple fact is investors may
resist the realization of a lossresist the realization of a loss
because it stands as proof thatbecause it stands as proof that
their first judgment was wrong.their first judgment was wrong.
• The quest for pride, andThe quest for pride, and
avoidance of regret lead to aavoidance of regret lead to a
disposition to realize gains anddisposition to realize gains and
defer losses.defer losses.

23. Self-ControlSelf-Control
• Self-control is portrayed as a conflictSelf-control is portrayed as a conflict
between a rational part (planner) and abetween a rational part (planner) and a
more primitive and emotional individualmore primitive and emotional individual
action (agent).action (agent).
• Planner may not be strong enough toPlanner may not be strong enough to
prevent the (emotional) reactions of theprevent the (emotional) reactions of the
agent from interfering with rationalagent from interfering with rational
decision making.decision making.
• An example, traders clearly aware thatAn example, traders clearly aware that
riding losers was not rational, but couldriding losers was not rational, but could
not exhibit enough self-control to closenot exhibit enough self-control to close
the position at a loss, thus limiting loss.the position at a loss, thus limiting loss.

24. Self-ControlSelf-Control
• Different pre-commitment techniques toDifferent pre-commitment techniques to
control the ‘agents’ resistance to realizingcontrol the ‘agents’ resistance to realizing
losses :losses :
1.Predetermined percentage loss1.Predetermined percentage loss
(e.g., ten percent)(e.g., ten percent)
2. Stop-loss order2. Stop-loss order
3. Funding an emergency3. Funding an emergency

25. Self-Control (December Trading)Self-Control (December Trading)
• The month ofThe month of DecemberDecember seems to haveseems to have
abnormal trading volume. The trading constitutesabnormal trading volume. The trading constitutes
tax loss selling which reflects self control.tax loss selling which reflects self control.
• This occurs because many investors want toThis occurs because many investors want to
benefit from the tax rebate and this is consideredbenefit from the tax rebate and this is considered
a rational act by many investors.a rational act by many investors.
• So we can perceive that self motivation is easierSo we can perceive that self motivation is easier
in the month of December than any other monthin the month of December than any other month
because of its deadline characteristic.because of its deadline characteristic.

26. • The major interest is whether investors time the realizationThe major interest is whether investors time the realization
of their losses differently than gains, and if so what is theof their losses differently than gains, and if so what is the
nature of the difference.nature of the difference.
• This evidence concerns the time that passes betweenThis evidence concerns the time that passes between
when an investor buys a stock and the point where hewhen an investor buys a stock and the point where he
sells it.sells it.
• Tax considerations suggest that losses should be realizedTax considerations suggest that losses should be realized
while they are short-term, while gains should be realizedwhile they are short-term, while gains should be realized
only when they are long-term. However the disposition toonly when they are long-term. However the disposition to
sell winners early and ride losers too long is the opposite.sell winners early and ride losers too long is the opposite.
Empirical EvidenceEmpirical Evidence

27. Empirical EvidenceEmpirical Evidence
• Individual trades by selected investorsIndividual trades by selected investors
between 1964 and 1970between 1964 and 1970
• A ‘round trip duration’ denotes the length ofA ‘round trip duration’ denotes the length of
time that an investor holds a stock beforetime that an investor holds a stock before
selling itselling it

28. Empirical EvidenceEmpirical Evidence

29. Empirical EvidenceEmpirical Evidence
• ApproxApprox 40% of all realization are losses40% of all realization are losses
• What do we infer about tax motivated asWhat do we infer about tax motivated as
opposed to disposition effect from the dataopposed to disposition effect from the data
Suppose that investors trade to take advantageSuppose that investors trade to take advantage
of the tax option and not subject to theof the tax option and not subject to the
disposition effect. Then we find there are fewdisposition effect. Then we find there are few
gains realized when they are short-term for 2gains realized when they are short-term for 2
reasons.reasons.
1.Tax rate is high on such gains1.Tax rate is high on such gains
2.Transaction costs involved in frequent trading2.Transaction costs involved in frequent trading

30. Empirical EvidenceEmpirical Evidence
• Thus the number of transactions where aThus the number of transactions where a
gain is realized should be very low forgain is realized should be very low for
roundtrip durations less than 6 monthsroundtrip durations less than 6 months
• On the other hand gains from high andOn the other hand gains from high and
medium variance stocks should bemedium variance stocks should be
realized as soon as the become long-realized as soon as the become long-
term. So the long number of transactionsterm. So the long number of transactions
should be high.should be high.

31. Empirical EvidenceEmpirical Evidence
• We conclude that tax-
induced trades form minor
portion of all trades.
• Another inference is that
Disposition effect offsets tax
motivated traders.

32. ConclusionConclusion
• Tax realization alone cannot alone explain the observedTax realization alone cannot alone explain the observed
patterns of loss and gain realization. Both the dispositionpatterns of loss and gain realization. Both the disposition
effect and tax considerations are consistent together.effect and tax considerations are consistent together.
• The four major elements of the ‘disposition effect’ placesThe four major elements of the ‘disposition effect’ places
this behavioral effect (sell winners and hold losers) into athis behavioral effect (sell winners and hold losers) into a
wider theoretical framework.wider theoretical framework.