When the disposition effect proves to be rational: Experimental evidence from professional traders

Abstract

The disposition effect is a behavioural finance anomaly that has been observed in many populations including non-professional investors as well as professional investors and has been linked to reduced trading performance. However, the majority of studies to date have looked at the disposition effect in the context of non-mean reverting markets. We conducted a within-subject experiment with n = 193 professional traders, to examine how the tendency towards the disposition effect varies across decision-making for mean reverting securities and non-mean reverting securities. In addition, we consider whether a simple informational intervention that makes the disposition effect salient can alter decision-making. Overall, we find that prior to the intervention the traders exhibit the disposition effect in the direction that aligns with profit maximisation goals suggesting that they are acting rational. For decisions on mean reverting securities the traders tend to make decisions in the direction of the disposition effect, which is rational given their mean reverting properties. We also find that the informational intervention is effective in changing the level of the disposition effect observed and decision-making, regardless of whether traders are considering decisions over mean reverting or non-mean reverting securities. Further, we provide evidence that our simple informational intervention improves trader returns when making decisions on non-mean reverting securities. In contrast, it has a negative impact when utilised for mean reverting securities. Our study highlights the power of simple interventions to make disproportionately large changes to decision-making regardless of whether they are in our best interests, and their beneficial role only when the context is right.

Keywords: G41; behavioural finance; commodities; disposition effect; prospect theory; trading decision-making JEL classification: G11.