Do the Disposition and House Money Effects Coexist?
The differential impact of realized and unrealized gains and
losses
Songyao YAO a, Darren DUXBURY a,*, Robert HUDSON b and Kevin KEASEY a
a
Centre for Advanced Studies in Finance (CASIF), Leeds University Business School,
The University of Leeds, Leeds, LS2 9JT, UK
b
Newcastle University Business School, Ridley Building, Queen Victoria Road,
Newcastle upon Tyne, NE1 7RJ
Abstract – short
Contrary to the assumptions of rational economic behavior, there is substantial evidence
that prior outcomes impact on financial behavior. Two important behavioral biases
illustrating the impact of prior outcomes have been documented in the financial markets;
namely the disposition effect and the house money effect. The two effects, however, are
premised on contradictory behavior, with the disposition effect requiring decreased risk
taking behavior following prior gains (selling winners) and increased risk taking
following prior losses (holding losers), while the house money effect requires increased
risk taking following prior gains and reduced risk taking following losses. Even after
aggregating the evidence from numerous empirical studies looking at one or other of
these behavioral biases, given the disparate datasets employed it is not possible to
comment on whether the two effects can contemporaneously coexist in a single financial
market, whether individual investors might succumb to both types of behavior or whether
the two effects might interact with one another. To address these important questions
requires a simultaneous examination of both biases using the same dataset, but this is
missing in the literature currently. This paper fills this gap in the literature and is the first
to show that the disposition and house money effects can contemporaneously coexist in a
single stock market, that investors can simultaneously succumb to both types of behavior
and that the house money effect moderates the disposition effect. In addition, in
reconciling such behavior we show the importance of distinguishing prior outcomes
along two dimensions; 1) unrealized or realized and 2) assessed at the stock or portfolio
level.
*
Corresponding author: email dd@lubs.leeds.ac.uk, telephone +44 (0) 113 343508
1
Abstract – long
For decisions based on rational economic principles (subjected expected utility theory)
the carrier of value is terminal wealth and individuals are assumed to be indifferent as to
how they arrive at this terminal wealth (i.e. changes of wealth do not factor in the
determination of utility). Thus prior outcomes should be irrelevant to individuals’ future
decisions. However, there is a growing body of research suggesting that prior outcomes
impact upon decision making via their influence on individuals’ risk attitudes. In a
finance context there is empirical evidence that investors are influenced by prior
outcomes (i.e. gains and losses), displaying a disposition to sell winning shares too soon
and hold losing shares to long, thus appearing to be risk averse in the presence of prior
gains and risk taking in the presence of prior losses (consistent with prospect theory).
There is also evidence, albeit less substantial, of contradictory behavior whereby
investors exhibit risk taking behavior following prior gains and risk averse behavior
following prior losses. So how can such seemingly contradictory risk taking behavior,
termed the disposition effect and the house money effect, respectively, be reconciled?
Neilson (1998) proposes a three-argument utility function that can account for the
coexistence of both types of behavior. Two implications of Neilson’s (1998) approach
are that it must be possible for the two effects to contemporaneously coexist in a single
financial market and that a single investor could simultaneously exhibit behavior
consistent with both effects.
Even after aggregating the evidence from numerous empirical studies looking at one
or other of these behavioral biases, given the disparate datasets employed it is not
possible to comment on whether the two effects can contemporaneously coexist in a
single financial market, whether individual investors might succumb to both types of
behavior or whether the two effects might interact with one another. To address these
important questions requires a simultaneous examination of both biases using the same
dataset, but this is missing in the literature currently. This paper fills this gap in the
literature using detailed transaction and position information for all investors registered
with a stock brokerage in Beijing. We find strong evidence that the disposition and house
money effects do contemporaneously coexist in a single stock market and that a
substantial proportion of investors simultaneously succumb to both types of behavior.
2
We draw an important distinction between the differing roles played by unrealized and
realized prior outcomes, with the former associated with the disposition effect and the
latter the house money effect. Moreover, whether the impact of the prior outcomes effect
on observed risk attitudes is investigated at the individual stock level or at the aggregate
portfolio level is an important determinant of whether we observe behavior consistent
with the disposition effect or house money effect, with the former only observed at the
individual stock level.
Furthermore, there is evidence that the house money effect
mediates the disposition effect, as we observe lower values of the disposition effect
measure in the presence of prior realized gains than in the presence of prior realized
losses.
Investor characteristics also have a role to play, with institutions, more
sophisticated investors, investors with higher wealth levels, and investors holding more
diverse portfolios, all being less prone to the behavioral biases than their counterparts.
3