Question

Explain the disposition effect

Explain the idea of nudging. Then give and explain a few (3 examples) of nudging.

Answer 1

Disposition effect is when we hold a position in security even though it is losing money but on the hopes to breakeven or to recover the lost money. Similarly, if we sell of position in a security which has gained but not to the expected level due to temporary market weakness and it went to make gains but it was sold off prematurely for much lesser gains. This can also be termed a disposition effect.

For example, if we buy a security for a price say 100 dollars, the price goes upto 110 dollars later it drops to 105 but the trader sells of at 105 fearing that there may be further losses in the market and realizes a gain of 5 dollars. Later, the trader observes that the price has increased above 110 but he no longer holds the position vis a vis the same applies for the losing positions.

Nudging Theory is a cognitive concept which is a form of influence or encouragement on an individuals decision making through attractive choices rather than through some mandates. For eg - Government decision to auto enroll the employees on pay roll for pension schemes which keeps increasing on par with the increasing in salary but decision to stay with the plan is left to the employee.

Another good example of nudging is Uber, Uber in order to encourage drivers to drive more would offer them incentives or redirect them to areas where there are more trips available which offers compelling choice between ending the day or choosing to continue to drive for some more time to drive more.

In companies, employees are given option to get salary in form of benefits which reduces tax in which case an employee does not need to rush to make last minute investment decision making to save for taxes or the employee has the option to opt out to get the salary amount credited to his/her account.