What looks large to you may not look large to her

We all know that size is relative. Some things may seem large to one person and only average to another. Whether it is in matters of biology or finance doesn’t seem to make much of a difference. One man may be proud of the large salmon he caught, but his wife may be completely unimpressed (what did you think I was talking about?).

When it comes to investments, we seem to fall for the same illusion of size in our portfolios. Take a look at the left-hand chart below. It shows the likelihood that an investor is going to sell a stock as a function of the stock return on the day before the stock was sold. The likelihood increases for larger positive and negative returns and is smallest after a day when the stock price did not move. But after gains, the likelihood to sell a stock rises much faster than after losses. This is the disposition effect as we know it. Investors are more likely to sell a stock where they made a profit than a stock where they made a loss. 

But now look at the right-hand chart that is based on an analysis by researchers from the University of Warwick. It shows the likelihood to sell a stock not just based on gains or losses, but also if these gains or losses were amongst the top 25% biggest gains or losses in the investor’s portfolio. For a conservative investor, a 5% gain may look like a large gain, while your average Gen Z Robinhood trader may probably just shrug it off as a calm day in the office.

It turns out that if you experience extreme gains or losses relative to what you are used to you are two times more likely to sell stocks after a gain and 4.5 times more likely to sell after a loss. In other words, you are freaking out about the size of your gains or losses much, much more than other investors. And because this effect is not only large but nonlinear, it pays for fund managers and private bankers who advise investors to not only look at returns relative to their peers or the market but also relative to the history of the client’s portfolio. It could be a better guide to the emotional state of the client than just looking at the percentage change in the investment.

Likelihood to sell an investment as a function of the previous day return

Source: Antoniou et al. (2021)