Reverse Disposition Effect of Foreign Investors

Abstract

The paper analyses the tendency of investors to realize gains too early and the reluctance to liquidate losing positions. Analysis is based on the complete transaction data of the Estonian stock market. The Cox proportional hazard model along with ratio analysis is used to measure the disposition effect. I find presence of the disposition effect on the market, but contrary to other investor groups, foreign investors seem to exhibit a "reverse disposition effect" that can be caused by different behavioral characteristics compared to local investors, especially risk aversion. Foreign investors are more driven by momentum strategies whereas local investors pursue the contrarian approach. Experience and investor sophistication seem to decrease the disposition effect. INTRODUCTIONNumerous studies have identified the tendency of investors to realize winning positions too early and be reluctant to realize losses. The bias is known as the disposition effect that was first documented by Shefrin and Statman [1985]. Various hypotheses have been offered, but the underlying causes for such behavior still remain unclear.The disposition effect has widely been explained by the prospect theory of Kahneman and Tversky [1979]. According to their theory, investors regard possible further gains less valuable than losses when having a winning position, and the other way round when facing a loss. However, recent work 1 shows that the prospect theory based models have a hard time predicting the disposition effect ex-ante. This is because investors would not buy such risky assets in the first place that can cause the disposition effect under their behavioral characteristics. In addition, recent work shows that the prospect theory-based explanation is more likely to predict the reverse of the disposition effect rather than the disposition effect. Current empirical studies have identified the disposition effect for all studied international stock and real estate markets as well as executive stock option exercise, but the reverse disposition effect has not been identified 2 for a distinguishable market or investor group.Interpretation of the recent prospect theory-based theoretical models poses a question whether there are investor groups behaving according to the more likely predictions of the models and thus can prevailingly exhibit the reverse disposition effect. Current empirical findings do not show the reverse disposition effect biased investors. If there were, we could study the traits distinguishing such investors and possibly offer more insights into the matter to see if and how well prospect theory-based models can predict the disposition effect related portfolio allocation and trading decisions. Empirical existence of the reverse disposition effect would mean that controversial results of prospect theory-based models can still accord to empirical findings, and there could be powerful factors having different influence on the decisions of different investor groups.To obtain results for various investor groups which enable to study...

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