Petrified in a bear market – until you see an exit sign
One of the most prominent findings of behavioural finance is the disposition effect. The disposition effect describes the tendency of investors to sell winners too soon and hang on to losers for too long. In essence, nobody likes to admit to themselves that they have made a mistake in their investments so when they suffer a loss, they try to hang on to that investment in the hope of regaining lost ground and sell it at a later point at a lower loss or maybe even a gain. Meanwhile, if investors are sitting on a gain, they are inclined to sell that investment so they can lock in those gains and forever brag about how good an investor they are to their friends. The disposition effect is so strong that it shifts the odds in horse racing for example and can lead to strategies that allow punters to systematically gain at horse racing over time (but that is a story for another time).
Obviously, one of the major problems with the disposition effect is that stocks move in trends, and selling your winners while hanging on to your losers leads to underperformance because more often than not, the winners are likely to rise even further in the near future while the losers are likely to decline even more. The other problem with the disposition effect is that if you have to pay taxes on capital gains, then selling winners while hanging on to losers is exactly the wrong thing to do from a tax perspective. It ensures that you pay taxes on the winners you sell but have no losses to offset these gains from the losers you keep in your portfolio.
The drivers of the disposition effect are by now pretty well understood. It is essentially a change in risk aversion when confronted with losses and a subjective change in mood as you experience gains or losses. Losses obviously make you more pessimistic in which case you tend to freeze up and rather do nothing than make a mistake. I usually say that in a bear market, investors get petrified.
But a new study has shown that the disposition effect gets stronger in bear markets. The chart below shows the likelihood of investors to sell a stock that is held at a gain in a bear market and in a boom market. Similarly, it shows the likelihood hood to sell a stock that is held at a loss in a bear or boom market. It is pretty obvious that while there is little difference in the propensity to sell an investment held at a loss, in a bear market, investors are far more likely to sell stocks held at a gain. In other words, investors are petrified in a bear market and try not to sell their losers. But when they see an exit sign in the form of an investment that has made a gain while the rest of the portfolio is down, they try to lock that gain in as fast as they can. And as you might have guessed, that is again exactly the wrong thing to do, since in a bear market, the losers tend to lose even more than normal, so hanging on to them while selling your few winners is really a bad idea.
The likelihood of investors to sell stocks in a boom and bear market
Source: Bernard et al. (2021).
..."more often than not, the winners are likely to rise even further in the near future while the losers are likely to decline even more"
Is this verifiable? By how much, for how long?
You are such a natural storyteller. I just love your writing.