Investors generally hate losing money. This aversion often leads to the disposition effect, which is the well-documented tendency for people to sell their winning investments quickly while holding on to losing investments for too long.
Most financial research studies this behavior by looking at completed transactions in a portfolio. A team of researchers decided to investigate the steps leading up to those transactions by analyzing the actual buy and sell orders investors submit to their brokers.
Researchers Rudy De Winne, Nhung Luong, and Stefan Palan investigated how the disposition effect influences the exact mechanisms investors use to trade. Their study, published in the Journal of Behavioral and Experimental Finance, shows that this behavioral bias is linked to distinct changes in the types of orders investors choose to submit.
Market orders versus limit orders
To understand these choices, it helps to know the difference between the two main types of stock market orders. A market order tells a broker to buy or sell a stock immediately at whatever price is currently available on the exchange.
A limit order specifies a minimum acceptable sale price or a maximum acceptable purchase price. While a market order guarantees the trade will happen, the final price is uncertain. A limit order guarantees the price, but it creates execution risk. If the stock never reaches the specified limit price, the order will simply expire without a trade taking place.
Prior research suggested that limit orders might create an artificial appearance of the disposition effect. If an investor sets a limit sell order above a stock’s current price, the order will only execute if the price goes up.
This creates a mechanical record of the investor selling a winning stock, even if they had no psychological preference for selling winners over losers. The researchers needed to find out if this mechanical effect rendered standard measurements of the disposition effect inaccurate.
Isolating the mechanics in the lab
The research team designed a laboratory experiment featuring 213 participants who traded five simulated stocks across two distinct rounds. The experiment simulated 30 trading days compressed into 30-second intervals, with each simulated stock carrying different underlying probabilities of increasing or decreasing in fundamental value.
In one round, the simulated trading environment only allowed participants to use market orders. This established a baseline disposition effect score for each trader that was completely free of any limit order mechanics. In the other round, participants were allowed to use both market and limit orders.
By comparing the two rounds, the researchers found that limit orders do introduce a slight mechanical bias. However, this bias did not completely scramble the traders’ behavioral profiles. An individual who showed a high disposition effect in the market-order round generally retained a high disposition effect ranking in the mixed-order round.
The authors interpret this consistency as validation for using real-world brokerage data. Even though real-world data is full of limit orders, it can still serve as a reliable proxy for identifying which investors are most prone to the disposition effect.
Anchoring to the purchase price
After confirming the validity of their metrics, the team looked at how a high disposition effect altered trading mechanics. In the simulated market, high-disposition traders were highly sensitive to their original purchase price. When holding a losing stock, they routinely refused to accept the current market value.
Instead of taking a loss, these investors submitted limit orders with prices set at or above their original purchase price. Because these limit prices were set far above the prevailing market price, the orders had a very low chance of actually executing.
To see if these patterns held outside the laboratory, the researchers analyzed trading records from a large Belgian online brokerage. The dataset covered more than 26,000 retail investors and included over 5.5 million individual orders submitted between 2003 and 2021.
The researchers divided this 18-year dataset into consecutive three-year windows. They used an investor’s trading history in one three-year window to classify their disposition effect level. They then analyzed that same investor’s order placement behavior in the subsequent three-year window.
Real-world trading patterns
The empirical data mirrored the laboratory results almost perfectly. Investors with a high disposition effect submitted a higher proportion of sell orders for winning stocks than they did for losing stocks.
When these high-disposition investors did try to sell a losing position, they consistently set their limit prices at or above their original purchase price. The researchers argue that this demonstrates an attempt to break even, regardless of how unlikely it is that the stock will bounce back to that level.
The brokerage dataset also allowed the researchers to look at the expiration instructions attached to these limit orders. Retail brokers typically let investors choose between day orders, which expire when the market closes, and good-till-cancelled orders, which remain active indefinitely.
The analysis showed that high-disposition investors were significantly more likely to attach good-till-cancelled instructions to their sell orders when a position was at a loss. Rather than letting the order expire at the end of the day, these investors opted to give the market as much time as possible to eventually reach their desired break-even price.
