Estimating the Loss from the Disposition Effect: A Simulation Study

Abstract

The disposition effect is the tendency of investors to sell winners too early and hold losers too long. We use a simulation model to estimate the loss attributable to the disposition effect using historical data from five different stock markets around the world in four time periods. We find that loss increases with the relative unwillingness to sell losers, and is not reduced by trading more often. We also find that delaying the sale of winning stocks, and applying a selling discipline that sells off stocks once they cross preset thresholds, can reduce the loss attributable to the disposition effect.

Keywords:

• Investor psychology
• Disposition effect
• Regret
• Discipline
• Mixed-effect regression

Notes

1. We do realize that while delaying the sale of winners is feasible in practice, back-dating the sale of losers is not practically feasible. We examine the latter in the spirit of a counterfactual (what-if) mainly to determine the extent to which holding losers too long contributes to the total loss attributed to the disposition effect.