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The study of how human instinct impacts on investment decisions is hotly debated and sometimes controversial. But even Ben Graham, the father of value investing, was aware of the potential for investors to err. He famously warned that “the investor’s chief problem – and even his worst enemy – is likely to be himself.” One of the best known behavioural trap-doors is to hang onto losing investments for too long and sell winning positions too soon. It’s a phenomenon known as the Disposition Effect. For years, researchers have warned that investors can damage returns by cutting winners and riding losers. Often, this warning has been pitched in the direction of relatively unsophisticated retail investors. But new research suggests that the same behavioural flaw exists in some of the market’s smartest and best-informed traders – Short Sellers. It serves as a reminder that the risk of succumbing to selling the wrong positions is something every investor needs to be aware of. So here’s a review of how things can go wrong and why smart investors are susceptible too. Why we sell the wrong shares If you were looking at a map of behavioural finance, you’d arrive at the Disposition Effect directly from two other places: prospect theory and mental accounting. These are theories about how humans make choices between risky prospects and how they categorise them based on different outcomes. In the context of investing, these theories claim that investors treat the probability of a loss differently to that of a gain. With the Disposition Effect, what this means is that investors irrationally sell winners and hold losers even though it often makes no economic sense. Some of the best research into the consequences of all this was done by Terrance Odean, who waded through 10,000 accounts held at an American discount broker between 1987 and 1993. He found a clear tendency for investors to sell winning positions over losing positions. Moreover, there was no good reason for it – there was no evidence that these investors were deliberately rebalancing their portfolios. On average, after one year, the losing stock, that was held, fell by 1.0% against the market. While the winning stock, that was sold, actually gained 2.4% above the market. Momentum rides on the Disposition Effect Clearly, Odean’s findings show that the Disposition Effect can damage performance – but not everyone loses. Readers of Stockopedia will know that we view Momentum as a core driver of market returns – as do a number of academics and investment professionals. So it’s worth mentioning at this point that the Disposition Effect arguably has a role in driving momentum. Given that research shows that investors sell winning positions too soon, there’s a read-across to companies that issue good news to the market. Some evidence suggests that the share price rise that goes hand-in-hand with good or surprising news can be artificially held back. And it’s held back by investors succumbing to the Disposition Effect and selling out of those ‘good news’ stocks too early. It causes something called post-earnings announcement drift, where the market takes a protracted time to price in the full meaning of the good news. This is one of the ways that momentum has been shown to work – very successfully for those who catch the wave. Smart investors make the same mistakes! If all this sounds a bit like like academics have been nit-picking at the fallibilities of individual investors, think again. In the evolutionary tree of the stock market, Short Sellers (despite their opaque nature) are regarded as some of the smartest investors around. Geared up to bet on shares that will fall in price means that they have to operate with a high degree of confidence. Ultimately, that means deep pockets and very detailed, industry-leading research. But very recent analysis shows that these guys are equally susceptible to the Disposition Effect. Watch out, we’re straying into the realms of double negatives here… but the evidence shows that short sellers are more prone to realising a capital gain on a falling share then they are to cut a losing position (i.e. a share that has risen in price). This is interesting stuff, not least because it hasn’t been looked at in detail before. In particular it shows just how powerful this natural urge to cut a winner really is. Plus it casts a small shadow over just how effective short selling is at making markets more efficient by pricing stocks correctly. The implication is that short sellers unwind profitable positions before they really should, or could do. The research was done by Bastian von Beschwitz (an economist at the US Fed) and Massimo Massa (a professor at INSEAD business school). They studied shorting activity on all US stocks between mid-2004 and mid-2010. Given the assumption that short sellers are very smart, there was a suspicion that they held on to losing (poor performing) positions because they knew they’d eventually come good. But it turns out this wasn’t the case – there was an element of irrational behaviour. Those profitable losing stocks became more profitable even after the short sellers had cut and run. As the researchers concluded: “…short sellers are closing more positions exactly at the time when it would be profitable to keep the short position open and profit from the negative future return. Thus, their tendency to hold on to their losing positions and close their winning ones causes them to lose money, a clear sign that it is not a profit maximizing strategy.” Circling back to the momentum connection, this new research also suggested that the Disposition Effect behaviour leads both long traders and short sellers to add to momentum. What can investors learn from this? For individual investors, news that the market’s most ruthless traders are prone to the same behavioural bias is perhaps quite reassuring. Unfortunately, it appears that individuals are more susceptible. Comparing Terry Odean’s 1998 research with their own, von Beschwitz and Massa found that the average retail investor suffered from a Disposition Effect that is approximately 6 times as strong as that of the average short seller. Overall, the findings reinforce many years of research that shows that selling winners too soon and holding losers too long can be costly. Dealing with this, of course, is another matter.