The disposition effect in the stockmarket
by Vivek Kaul
I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful. - Warren Buffet
MUMBAI: Investors are ready to take more risks when it comes to bringing down their losses. When it comes to selling stocks which have been going up, investors tend to do that too soon.
Ganesh Sharma had just turned thirty. But as far as stockmarket investing was concerned he was a veteran, having invested in the markets for almost a decade now. He had invested big time during the Ketan Parekh-led boom in the stockmarket.
And yes, he had lost big time. Stocks, which had quoted at over Rs 1,000 during those days, had fallen like a house of cards.
First he had not sold them hoping they would go up more and then he had held them on with the hope that some day their prices will go up again.
Now almost five years down the line, nothing has happened and most of his bets are still loss making propositions.
Now let's take a look at the following situation: An individual plays a game where in, he is either guaranteed Rs 2,000 or a coin is flipped. If its head, the individual gets Rs 4,000 if its tail he does not get anything.
Which option would the individual choose? Research suggests that most individuals would go in for a guaranteed gain of Rs 2,000.
Now let's consider another situation: An individual plays a game where in a coin is flipped, if it's a tail he loses Rs 4,000, if it's a head he does not lose anything or he has an option of not playing the game by paying Rs 2,000 up front.
Which option would the individual choose? Research suggests that more individuals will choose the first option and go in for a toss of the coin rather than take a guaranteed loss of Rs 2,000.
So does this tell us something about Sharma's investment strategy gone awry? Investors are ready to take more risks when it comes to bringing down their losses. This explains why Sharma kept hanging onto his investments. He was just hoping that the prices will go up and he would be able to reduce his losses.
Also investors hate to acknowledge the fact that they have made a mistake and hence tend to hang on to losing propositions much longer. By holding on they tend to avoid the action that confirms the fact that a mistake has been made.
On the flip side, when it comes to selling stocks, which have been going up, investors tend to do that too soon. How many times have you heard in the last year about an investor wailing about the fact that he shouldn't have sold so soon.
The first bottle of a cola drink, on a hot summer afternoon, with the mercury rising every moment, can be a delight while you would no longer be sure of the taste by the time you have had the fifth bottle of cola.
Now applying this analogy to the stock market. Investors are more pleased with the first rupee of gain vis a vis the second rupee, the second rupee of gain vis a vis the third rupee and so on.
This decreasing sensitivity has the same effect even when investors are losing money. Investors are more annoyed by the first rupee lost vis a vis the second rupee, the second rupee of loss more than the third and so on.
This makes them just hang on to the loss-making investment. This tendency of investors to book profits too early and too hang on too losses too long is referred to as the disposition effect. This disposition effect plays a major part in the way investors behave in the stock market.
After the bust of 2001, it led to a whole lot of investors who had burnt their fingers in the market staying away from the market and swearing by fixed income instruments. And now that the markets are going up again some of them are still hanging on to those dud stocks that bought them so much pain in the hope that they may go up again.
(The example used is hypothetical)
Source: DNA Money, Original Link : Click Here
