Discuss the two reasons that the disposition effect hurts investment performance

Expert Solution

The disposition effect is an anomaly discovered in behavioral finance. It relates to the tendency of investors to sell shares of the company whose price has increased while keeping shares of the company whose price has dropped.

The disposition effect is coherent with predictions from prospect theory about how people perceive losses. Prospect theory states that individuals are a loss- (and risk-) averse when facing positive outcomes (gains), and risk-seeking when facing negative outcomes (losses). As a result, investors prefer to hold the loser, just as they prefer to accept a gamble instead of a sure loss, even if the gamble is characterized by the probability of losing more money than the sure loss

The disposition effect is also coherent with theories about decision regret. Winners are sold quickly because investors prefer to avoid regret due to a market trend change that can reduce their gains. More often, though, investors tend to sell winning stocks while their value is still rising.

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