In this paper, Shefrin and Statman argue that investors tend to sell winners too early and ride losers for too long. They call this the disposition effect. The theory is based on the following concepts.
- Prospect theory: We are risk-averse in terms of gains and risk-seeking in terms of losses.
- Mental accounting: We treat each investment as a mental account and do not see things as a whole
- Pride and regret: Pride and regret move us to ride losers longer.
- Self-control: Most people tend to follow our emotional part (point 3)
Prospect theory suggests that investors show a tendency to sell winners and keep losers for too long. The investors have an S-shaped valuation function (a utility function which displays the domain of gains and/or losses). The below graph shows the shape of the s-function which is a function of utility relative to gains/losses against our reference point (wealth). Gains exhibit a concave (risk-averse) tendency, and the losses exhibit a convex (risk-seeking) tendency.
The main idea of mental accounting is that people tend to divide the different types of investments into separate accounts and then apply prospect theoretic rules to each one and to ignore the possible interaction between the investments. Each investment is in itself a mental account, and it is hard to close the account when the investment is at a loss.
Seeking Pride and Avoiding Regret
Investors may resist realizing losses because it would stand as a proof of that they misjudged the investment. Investors also want to avoid informing others about their misjudgment. The quest for pride and avoidance of regret lead to a disposition to realize gains and defer losses.
The Thaler-Shefrin framework looks at self-control as an interpersonal (agency) conflict between a rational part (the planner) and an emotional part (the doer). As mentioned before then investors will ride losers to postpone regret and sell winners “too quickly” because they want to hasten the feeling of pride at having chosen correctly in the past. It is the doer (emotional) part which is associated with the emotional reactions of regret and pride. The rational part fails to control our emotional parts.