Question

8. Explain the disposition effect. Then explain an investment strategy based on the disposition effect.

Answer 1

The disposition effect has been described as "one of the most robust facts about the trading of individual investors" because investors will hold stocks that have lost value yet sell stocks that have gained value.
Researchers have found the reason of the disposition effect to so called "prospect theory", which was first founded and named by Daniel Kahneman and Amos Tversky in 1979. Kahneman and Tversky both stated this as, "losses have more emotional effect than an relevant amount of gains," and that people thus base their decisions not on past losses but on past gains. If presented with two balanced options, one explained in terms of possible gains and the other explained in terms of possible losses, they would choose from the first choice, even though both would yield the same economic end result.
For instance, even when the net result of receiving $25 will be the same as the net result of gaining $50 and then losing $25, people would tend to take a more favorable view of the first than of the second scenario.