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Adding Alpha by Defusing the Disposition Effect
(Or Tying Yourself to the Mast)

Active Tax Management
October 19, 2017

In 1979, Daniel Kahneman and Amos Tversky published "Prospect Theory: An Analysis of Decision Under Risk." Regarded as perhaps the seminal paper in behavioral economics, the article’s central idea is that “losses have more emotional impact than an equivalent amount of gains.” Related to Kahneman’s and Tversky’s findings, in 1985, Hersh Shefrin and Meir Statman, in their paper "The Disposition to Sell Winners Too Early and Ride Losers Too Long: Theory and Evidence," documented the behavioral tendency of investors to sell shares whose prices have increased and keep shares whose prices have decreased. This tendency, referred to as the disposition effect, was further investigated by Nicholas Barberis and Wei Xiong, in a 2009 article in The Journal of Finance, "What Drives the Disposition Effect? An Analysis of a Long-Standing Preference-Based Explanation," in which they state:

"One of the most robust facts about the trading of individual investors is the "disposition effect": when an individual investor sells a stock in his portfolio, he has a greater propensity to sell a stock that has gone up in value since purchase than one that has gone down."

Next to the overconfidence that leads to buying high and selling low, the disposition effect (keeping losers and selling winners) is another behavioral tendency that can hurt investor performance. That is especially true for taxable investors in that it is exactly the opposite of what they should be doing, all else being equal: selling losers in order to recognize losses that can be offset against gains elsewhere in their portfolios, and holding winners in order to defer recognizing gains and paying taxes today that might better be put off to another day (or even avoided entirely, in the event of a basis step-up by the investor’s heirs).

One effective way for a taxable investor to overcome the disposition effect may be to switch from the emotions-driven decisions that come from wanting to avoid negative feelings associated with admitting one has “failed.” In fact, investors dislike realizing losses in an accounting sense because it forces them to realize those losses in a psychological sense that can harm self-image. Tax-advantaged indexing may avoid the irrational self-image trap by automatically selling stocks that have dropped in value and holding (not selling!) stocks that have appreciated in order to maintain the very valuable tax deferral on any gains. In our experience, we’ve never encountered a computer-driven algorithm that feels bad about itself because it bought a stock a few months ago that happened to go down.

In an empirical study by Aperio Group of tax-advantaged indexing (loss harvesting) over the 43-year period January 1973–February 2016, “The Tax-Loss Harvesting Life Cycle,” all 408 historical simulations of an S&P 500–tracking portfolio generated positive tax-alpha (gross of fees) at a 10-year horizon for both estate/donation and liquidation dispositions. Such a strategy can be viewed as the modern day equivalent of the approach of Odysseus, a character from Greek mythology, in his journey home from the Trojan War. At one point, Odysseus needed to sail his ship past the Sirens, famous for making men go crazy and crash their ships onto cliffs. To avoid that fate, Odysseus had his men to tie him tightly to the mast of their ship (while they plugged their ears) so when he heard the Sirens’ song he wouldn’t be lured to his demise. Odysseus, like a savvy investor, knew how to avoid the normal human susceptibility to bad choices we all face and constrain his own behavior such that he wouldn’t be able to do himself harm.

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