Last month we spoke about avoiding regret and how that influences our decisions. I introduced the irrational behaviour apparent when people sell shares: that of selling shares that have made a profit (winners), rather than those that have made a loss (losers). It’s known as the ‘disposition effect’, where we sell shares that performed well in the past as opposed to shares that we expect to perform poorly in the future. And we behave this way because we’re trying to avoid regret.

The ‘disposition effect’ is a close cousin of ‘loss aversion’, which we’ve discussed before: the unwillingness of investors to face up to a loss.

The ramifications of the disposition effect are far-reaching as they extend beyond the point at which a sale is made. Michal Ann Strahilevitz, Terrance Odean and Brad Barber documented this in their paper ‘Once burned, twice shy’. They found that after an investor had sold shares that had previously made them a profit, they were inclined to buy back these shares, rather than those they had sold which had made them a loss. Furthermore, investors would buy back a share that was trading at a lower price than what they’d previously sold it for, but not for a higher price. You get a good feeling from doing it, but can you see the potential nonsense in it all?

And let’s be clear, it’s not the fact that a share is held at a loss or a profit that’s the issue here, it’s the fact that a choice was made to buy the share in the first place. Being a choice, it could’ve gone either way, and that’s what triggers the regret and the attempts to avoid it. And the easier it is to visualise a happier alternative, the more heightened the regret.

So besides being aware of this, how can we use this information to our advantage?

We generally see that with good news, share prices rise, and with bad news, they fall. But John Nofsinger found the formula to be:

Good news = Share price rises = Investors sell shares, or

Bad news = Share price falls = Investors do nothing

Whilst this is consistent with the disposition effect, it suggests an interesting trading strategy … the opportunity to acquire shares of companies that might perform well in the short term at a discount?

Author: Gizelle Willows CA(SA) MCom Finance is Senior Lecturer in Financial Reporting at the University of Cape Town