Coexistence of disposition investors and momentum traders in stock markets: experimental evidence

Prior research documents that many investors disproportionately hold on to losing stocks while selling stocks which have gained in value. This systematic behavior is labeled as the “disposition effect”. The phenomenon can be explained by prospect theory's idea that subjects value gains and losses relative to a reference point like the purchase price (PP), and that they are risk-seeking in the domain of possible losses and risk-averse when a certain gain is obtainable. Our experiments were designed to test whether individual-level disposition effects attenuate or survive in a dynamic market setting. We analyze a series of 36 stock markets with 490 subjects. The majority of our investors demonstrate a strong preference for realizing winners (paper gains) rather than losers (paper losses). We adopt different reference points and compare the behavioral patterns across three main trading mechanisms, i.e. rules of price formation. The disposition effect is greatly reduced only within high-pressure mechanisms like a dealer market (DM) when the last price (LP) is assumed as a reference point, which is a more market driven (external) benchmark. If disposition investors use the PP as a reference point, which is a more mental-accounting driven (internal) benchmark, they die hard in all market settings. Interestingly, our markets do not collapse or become illiquid by disposition investors' reluctance to trade. A main reason for this is the coexistence of two or more groups of investors, e.g. momentum traders and disposition investors.