Jacopo Magnani of UC Santa Cruz presents "The Disposition Effect and Realization Preferences: A Direct Test"
This paper develops a new laboratory test of the hypothesis that individual investors have an irrational preference for selling winning stocks vis- a-vis selling losing stocks. In the experiment, subjects invest in a security that bundles a risky asset, whose price evolves in near-continuous time, and a perpetual put option. Impatience and liquidation of the investment are induced by random expiration. Optimal behavior is characterized by an upper and a lower selling thresholds in the asset price space, thus
producing a clear rational benchmark and eliminating well-known confounds. Subjects tend to delay selling losers beyond the optimal point and anticipate selling winners before the optimal liquidation time. The median liquidation points imply an expected fraction of winners in total sales 56% larger than optimal. I demonstrate that this behavior is consistent with a model of an investor who derives both consumption utility from liquidation and psychological utility from realizing gains and losses. I then
estimate the model using tick-level data on liquidation decisions and inaction spells. Structural estimates reveal that the sensitivity of realization utility to gains and losses is diminishing and decreases faster than what is implied by canonical estimates of prospect-theoretic value functions. A direct estimate of the degree of diminishing sensitivity is an important input for behavioral finance theory as even qualitative results of realization utility models, such as whether investors voluntary realize losses or not, depend on the value of the sensitivity parameter.
Keywords: Laboratory experiments, disposition e ffect, realization utility, reference-
dependent preferences, option exercise.