Investors have a tendency to sell assets that have earned them positive returns and are reluctant to let go of those that have brought them losses. This behavioural bias is called “disposition effect” and is attributed to loss aversion and regret avoidance. It has been widely documented by empirical research. The prevalence of the disposition effect is a key motivation behind trend following strategies. Now there is evidence that this effect is also cyclical: it seems to be stronger in market “bust periods” than in “boom periods”. This is consistent with prospect theory and heightened risk aversion in market downturns.

The below is a summary based mainly on:  Bernard, Sabine, Benjamin Loos, and Martin Weber (2020), “The Disposition Effect in Boom and Bust Markets”.
Some other research has been used and sources are linked after the quote.

The post ties up with this site’s summary on implicit subsidies in financial markets.

What is the disposition effect?

“The disposition effect, namely investors’ tendency to sell winners more frequently than losers, is one of the most explored [behavioural biases] in finance. A large number of studies document the presence of the disposition effect among different investor types, in various asset classes, and across geographical regions.”

“The disposition effect creates an artificial headwind: when good news is announced, the price of an asset does not immediately rise to its value because of premature selling or lack of buying. Similarly, when bad news is announced, the price falls less because investors are reluctant to sell. This is another explanation for why prices might underreact, and…has a large impact on the momentum premium.” [Tobias Moskowitz]

“The disposition effect and momentum are key determinants in the separation of outperforming investors from underperforming investors.” [Hersh Shefrin]

How to measure the disposition effect?

“The standard regression specification for measuring the disposition effect uses the following equation:

Sale(i,j,t) = beta0 + beta1*Gain(i,j,t) + error(i,j,t)

where observations occur at the investor (i), stock (j), and month (t) level. Sale is a dummy variable that equals one if the volume of asset j decreases between the previous month and today in investor i’s account, and zero otherwise. Thus, we include total as well as partial sales in our analysis. Gain is a dummy variable that is equal to one if the value-weighted average purchase price of stock j is smaller than the current market price of stock j, and zero otherwise.
The constant (beta0) measures investors’ propensity to sell a stock at a loss, whereas, the sum of the constant and the gain coefficient (beta0+beta1) measures investor’s propensity to sell a stock at a gain. Hence, beta1 measures the disposition effect, the difference between propensity to sell at a gain and the propensity to sell at a loss.”

Evidence for a countercyclical disposition effect

“We find that the disposition effect moves countercyclically to the stock market, i.e. is low in boom periods and high in bust periods. This change in investors’ selling behavior across cycles is mainly driven by their increased gain realization in bust markets and can be linked to changes in preferences, as well as changes in belief of individual investors…The disposition effect and the stock market return are negatively correlated with a Pearson’s correlation coefficient of -0.76.”

“Analyzing investors’ selling behavior over a range of return intervals (-30% to +30%) rather than just focusing on positive versus negative returns, we find that investors are always more likely to sell an asset in a bust than in a boom period – irrespective of the gain’s/loss’s magnitude.”

“Examining…a range of return we further find differences in gain realization to be strong across boom and bust markets [and] differences in loss realization to be neglectable across boom and bust markets…This is in line with theory predicting changes in the coefficient of risk aversion do primarily affect gain and not loss realizations [see below].”

“We find that – over the whole cycle duration – bust investors are always more likely to realize their gains than boom investors. This is consistent with bust investors being more pessimistic about future returns which makes them lock in their gains as early as possible.”

Why is the disposition effect countercyclical?

“Experimental literature exploring changes in investors’ preferences shows that investors are more risk averse in bust periods  or in negative emotional states such as anxiety…There [is] evidence that investors’ beliefs are positively correlated with past stock market returns which makes investors overly optimistic (pessimistic) in boom (bust) periods…Therefore, investors should be always more likely to lock in gains during bust than during boom cycles – irrespectively of the time stage of the cycle.”

“The notion that macroeconomic conditions impact investors’ beliefs is also found using survey data…[Research papers] find investors’ expectations to be extrapolative and influenced by economic conditions, i.e., to be positively correlated with past stock market returns.”

Why do bust periods mainly increase the propensity to sell at gain?

Prospect theory predicts that the propensity to sell a stock declines as its price moves away from the reference point. Hence, the function of the value of selling an asset minus the value of holding on to an asset decreases with a gain’s/loss’s magnitude. If investors become more risk-averse in bust periods, this function will shift upwards predicting a higher propensity to sell at a gain and propensity to sell at a loss in bust than in boom periods.”

N.B: Prospect theory is a popular model of irrational decision making. It emphasizes a realistic mental representation of expected gains and losses and an individual’s evaluation of such representations. Prospect theory explains asymmetric loss aversion. View full post here.

“Moreover, a [rise in] risk aversion will have a stronger effect on propensity to sell at a gain than on propensity to sell at a loss since changes in….risk aversion will affect investor’s decision problem in the gain domain through the value of selling and the value of holding on to the asset, whereas, in the loss domain [the increase in risk aversion] only affects the value of holding on to the risky asset.”