GCOE Discussion Paper Series
Global COE Program

Human Behavior and Socioeconomic Dynamics
Discussion Paper No. 296

Disposition Effect and Loss Aversion: An Analysis Based on a
Simulated Experimental Stock Market

Youki Kohsaka, Grzegorz Mardyla, Shinji Takenaka and Yoshiro Tsutsui

February 2013

GCOE Secretariat
Graduate School of Economics

OSAKA UNIVERSITY

1-7 Machikaneyama, Toyonaka, Osaka, 560-0043, Japan

Disposition Effect and Loss Aversion: An Analysis Based on a
Simulated Experimental Stock Market
Youki Kohsaka†
Grzegorz Mardyla‡
Shinji Takenaka§
Yoshiro Tsutsui¶

Abstract
We experimentally investigate the existence of and possible origin of the disposition effect. Our
approach has three distinct characteristics: Firstly, we created an experimental environment thatclosely mimics a real stock market and were thus able to obtain and analyze trading behavior
data that accurately depicts actual individual investor trading behavior. Secondly, based on aquestionnaire survey we conducted during the experiment, we were able to pinpoint eachindividual participant’s reference point. This, in effect, allowed us to verify an independent
hypothesis of the existence of the disposition effect – such an approach differs from the extant
literature, where only a joint hypothesis has been examined so far. Thirdly, we measured
individual loss aversion coefficients and directly tested whether loss aversion is a cause of thedisposition effect. Our results indicate both the existence of the disposition effect as well as
prospect theory’s loss aversion being one of its sources.
JEL classification codes: G02
Keywords: disposition effect, loss aversion, investor behavior, experimental economics

An earlier version of this paper was presented at the 6th annual meeting of Association of Behavioral
Economics and Finance and at a conference held at Hosei University. We are grateful to the participantsof these events for useful comments. We also express gratitude to Hiroshi Izawa, Jie Qin and Shunichiro
Sasaki for helpful comments and constructive collaboration during early stages of this project.
†
Waseda University Center for Finance Research, Email: kohsaka@aoni.waseda.jp‡
Kinki University Faculty of Economics, Email: greg@kindai.ac.jp§
Japan Center for Economic Research, Email: s.takenaka@jcer.or.jp¶
Osaka University Graduate School of Economics, Email: tsutsui@econ.osaka-u.ac.jp

11. Introduction
The purpose of this paper is to examine the existence and causes of the disposition effect.
Empirical evidence points to the fact that individual investors exhibit a tendency to hold on tolosing stocks for too long, thereby incurring excessive negative returns. While numerous
informal “advice on investing” books have been written on how to avoid the trap of being
unable to cut one’s losses early, careful scientific studies are called for since casual observations
often suffer from representative biases. We attempt in this paper a careful examination of thedisposition effect aiming to shed some light on whether it really is difficult to sell stocks trading
on a loss and if so, what are the underlying processes behind it.
There are two basic strands of extant research on this topic. The first one entails empiricalinvestigations of real world financial transaction data, while the second consists of laboratory
experiments. Papers in the first strand analyze data from various security markets around theworld. Some representative empirical work, all of which confirms the existence of thedisposition effect, includes: Odean (1998) – USA stock market; Grinblatt and Keloharju (2001)– Finnish stock market; Coval and Shumway (2005) – The Chicago Board of Trade; Shumway
and Wu (2006) – Shanghai stock market; Fogel and Berry (2006) – 176 members of theAmerican Association of Individual Investors; Misumi at al. (2007) – Tokyo Stock Exchange;
Choe and Eom (2009) – South Korean futures index market.1 As far as the second type ofliterature is concerned, the disposition effect has also been obtained in laboratory experiments
conducted on a range of subjects in diverse locations, including: Weber and Camerer (1998) –university students in Germany; Chui (2001) – university students in Macau; Kirchler et al.

1

Choe and Eom (2009) find in addition that individual investors are much more susceptible to thedisposition effect than institutional and foreign investors.

2(2005) – university students in Vienna; Rubaltelli et al. (2005) – university students in Italy;
Vlcek and Wang (2007) – university students in Switzerland; Shiroshita (2009) – university
students in Japan.
Empirical data analyses of the disposition effect are valuable in that they directly test for its
existence in real world financial markets. Experimental research on the other hand, while itcannot discard the possibility that a “disposition effect” discovered in the laboratory is in fact
distinct from its real world counterpart, has the undisputed merit of allowing for a strict control
over and accurate design of the environment stocks are traded in. On top of that, individual
investor information that is vitally important yet difficult or impossible to obtain in empiricalstudies can be acquired relatively easy in experimental settings. In our case, this type of
information takes the form of individual-specific reference points, degree of loss aversion, andpersonal and demographic attributes of our experiment subjects. As such, economic experiments,
besides offering another avenue to test for its existence, permit also the opportunity to seek forpotential causes of the disposition effect.
There exists a multitude of candidate explanations for the apparent prevalence of thedisposition effect. Below we enumerate and briefly describe the most salient of those.
(1) The shape of the value function from Kahneman and Tversky’s (1979) prospect theory,
which implies risk aversion in the domain of gains and risk seeking in the domain of
losses. In this paper, we refer to this phenomenon simply as “loss aversion”.2(2) Belief in reversion to the mean: If investors believe that stocks trading at a loss willrebound in the future with high probability, holding on to such stocks might be optimal.
2

While it is common in the literature to refer to “loss aversion” as the disproportionately amplified effectlosses, as opposed to gains, have on utility levels, in this paper we use the term “loss aversion” torepresent a general tendency to avoid the realization of losses.

3(3) Portfolio rebalancing: Investors might wish to maintain a constant proportion of certain
stocks in terms of cash value in their portfolios. This would lead them to rationally holdon to or even buy more of the losing stocks.
(4) Transaction costs: All other things equal, selling out losing stocks entails higher per-unit
transaction costs. This, in turn, implies that holding on to them is the smart thing to do.
(5) Psychologically-motivated reasons, such as mental accounting, regret aversion, andself-control (Shefrin and Statman (1985)).
(6) Taxation system: Although early research on the disposition effect (Shefrin and Statman(1985), Lakonishok and Smidt (1986), Odean (1998)), following Constantinides’ (1984)
exposition of a rational loss realization model, pointed to tax-related issues as one of its
possible causes, tax exemption rules associated with capital losses imply behavior thatwould result in an alleviation of any disposition effect-type of behavior.
Odean (1998) conjectured that loss aversion might bring about the disposition effect and,proving its existence in a large data sample at the same time eliminated other factors as its
possible sources. In particular, Odean’s (1998) results do not support the trading costs
hypothesis, which is shown to be inconsistent with the disposition effect: investors in his sample
sell winners more frequently than they sell losers regardless of transaction costs. Also, by
eliminating from his analyses trades that may be motivated by a desire to rebalance, he
effectively controlled for portfolio rebalancing. Odean (1998), while initially reluctant to reject
belief in mean reversion as a potential cause of the disposition effect refers later on to hiscomplementary analysis based on the same data sample (Odean (1999)). Therein he finds thosesame investors tend to buy stocks that have outperformed the market in the past, whereas a4belief in mean reversion implies precisely the opposite.
Weber and Camerer (1998) use an experimental setup and find their participants to besignificantly more inclined to buy stocks trading at a loss as opposed to those trading at a gain.
They attribute these findings to reversion to the mean, or, more generally, to misperception ofstochastic processes.
It has been widely believed that concavity of prospect theory’s value function in the domainof losses accounts for the disposition effect. This belief, however, has in turn come to bequestioned recently. Kaustia (2010) parameterizes cumulative prospect theory’s S-shaped valuefunction (Tversky and Kahneman (1992)) to show that propensity to sell is highest at reference
point (buying price) and declines when either gain or loss becomes larger. Strangely enough themodel predicts that holding any stocks is more beneficial than selling in most of the cases. On
the other hand, he finds empirically using Finnish transaction data that the propensity to sell astock does not decline as gains or losses increase but rather it is increasing or constant in thedomain of gains and insensitive to returns in the domain of losses. In other words, there is a
discontinuity (a “jump”) in the investors’ attitudes towards selling exactly at the point where
capital gains are zero. Given these evidences, he concludes that the S-shaped value function
cannot predict the pattern of realized returns found in the data and hence that the disposition
effect is unlikely to be driven by preferences dictated by prospect theory.
Barberis and Xiong (2009) study theoretically the trading behavior of an investor withprospect theory preferences and conclude that for a significant range of parameter values, theprospect theory predicts that investors will be more inclined to sell stocks with prior annual
losses than stocks with prior annual gains – exactly the opposite to what the disposition effect5

leads to. 3 However, when prospect theory is defined over realized gains and losses then thetheory indeed does predict a disposition effect, although not for all values of the parameters; forsome values, the opposite prediction still materializes.
In view of these recent results, the question of what type or shape of the value function (ifany, indeed) is consistent with the disposition effect remains an open one, at least for now. In
fact, a more general and more important question of whether prospect theory preferences maylead to the disposition effect is left unresolved, as well. This paper is an attempt at a resolutionof these questions.
Our approach employs the following three distinct characteristics. Firstly, we use data
generated through an experiment designed to mimic as closely as possible a real world security
market – our data is thus very similar to real stock market data. Specifically, the simulated
market in our experiment lasts four weeks and is open four and a half hours each trading day –exactly like the Tokyo Stock Exchange. However, our market is open in the evening hours tofacilitate frequent trading. We use real world past price data for 10 stocks from the TSE edited
from tick data so that the prices are updated every two minutes. 4 Participants in our
experimental market can trade at any time the market remains open. Remuneration fromparticipation in the experiment is proportional to the earnings (or losses) they acquire throughtrading. Thus we may assert that any results obtained through the experiment mimic closely
those of a real world stock market.
The second characteristic lies in the directness of our method to test the hypothesis ofwhether loss aversion leads to the disposition effect. We assess whether the degree to which

34

Hens and Vlcek (2011) derive an analogical result.
This method guarantees that subjects of the experiment will be able to trade at the price they desire to.

6subjects are prone to exhibit loss aversion predicts the strength of the disposition effect. To thisend, we perform supplemental experiments measuring our subjects’ degrees of risk aversion inboth domains of gain and losses. This method allows a more general inquiry into the potential
causality relation between loss aversion and the disposition effect and thus an improvement overprevious studies by Kaustia (2010) or Barberis and Xiong (2009) who resort to rather strictassumptions based on a particular form of the value function.
The third characteristic is linked to Odean’s (1998) observation that testing for the
disposition effect is equivalent to testing the joint hypothesis for the disposition effect and forthe reference point. Assuming a particular value for the reference price – e.g. first purchase price,
last purchase price, weighted average purchase price, etc. – has been the standard practice usedin empirical research on the disposition effect. This practice does constitute a type of robustness
check of the results obtained, but it ignores the possibility of heterogeneity in reference points
across investors. To address this problem, using a questionnaire survey we solicit individual
participants’ reference points and use obtained values when calculating gains and losses. In
effect, our method constitutes an independent test for the disposition effect, not merely a test forthe joint hypothesis.
Our analyses, employing the characteristics spelled out above, clearly confirm existence ofthe disposition effect and point to loss aversion as being one of its causes.
The rest of this paper is arranged as follows. In the next section we describe theexperimental design and methods. In Section 3, we explain techniques used to analyze the data.
In Section 4 we report main results and robustness checks involving subjects’ personal attributes
as well as verify that our results remain unaffected when alternative values are substituted for7

individual reference points. We wrap up with conclusions in Section 5.

2. Experimental Design and Procedures
Our design contains the main “Stock Trading” experiment, where participants buy and sellshares in a simulated security market, and the supplemental “Insurance Buying” and “Lottery
Selling”, where we measure participants’ risk aversion in the respective domains of losses andgains.

2.1. Stock Trading Experiment2.1.1. Outline of the Experiment
The “Stock Trading” experiment requires its participants, each afforded with an initialendowment of shares and virtual cash, to buy and sell shares of 10 companies in a simulated
stock market accessed through the internet. The market lasts for four weeks and is open for fourhours and thirty minutes every day from 18:00 through 22:36 (with a six minutes break from
20:00 to 20:06).5
The stock price data we use is authentic middle price tick data from the past edited so that it
is updated every two minutes. 6 In this way, we avoid any possible negative auto-correlation
issues resulting from the bid-ask spread we might have otherwise encountered if we had used

5

The six minutes break replicates lunchtime break from 11:00 through 12:30 instituted in the Tokyo
Stock Exchange.
6
Specifically, we randomly selected ten high-liquidity stocks traded on the Tokyo Stock Exchange andfor each extracted 33 days worth of tick data from “Nikkei Tick Data”. We subsequently created for eachof the ten stocks a vector of mid-quotes corresponding to those observed at the mid-quotes of 2-minuteintervals in the original data file and used morning period mid-quote data for the 18:00 through 20:00
experiment trading period, and afternoon mid-quote data for the 20:06 through 22:36 trading period. On
top of that we performed a simple linear transformation on the data to preclude any possibility ofidentification of actual stocks by the participants.

8

actual execution prices. Subjects in our experiment are guaranteed that their trades are going to
be carried out exactly at prices shown on their monitors and that those prices are not in any way
affected by their own nor by other subjects’ quantities demanded and quantities supplied. 7
Short-selling and negative cash positions are not allowed.
The initial endowment of each participant consists of 10 shares of each of the ten stocks and acash allotment of 10,000,000p (“points”). Participants have access to a transaction panel (Figure1) through which they get information on the present composition of their portfolios, stock
prices and cash holdings. The panel also allows them to order buy and sell trades, which are
immediately executed: for instance, by changing the number of shares in the “After Transaction”
column and clicking on “Execute Trade”, a corresponding order is completed. Traders in our
experiment also have access to graphs representing both the paths of past prices (closing quotes)
until the present day and that day’s price paths, starting from the opening bell until the present
time. 8 There are no dividends or transaction costs, nor are there any taxes. This differs from realworld markets but confers the merit of excluding from analysis the above-mentioned factors as
possible explanations for the disposition effect.

2.1.2. Compensation Structure
Participants receive three types of compensation. The first type depends on the number of days
they logged on to the experiment homepage throughout its duration. In addition to ¥30 for eachday one logged on, subjects are entitled to receive a bonus payment of a few thousand yen if

78

Consequently, experiment participants emulate small individual investors facing a highly liquid market.
On the first day of the experiment, data from preceding five trading days is made available.

9they accessed the system on at least 18 days. 9 The second type of compensation iscommensurate with the final portfolio return – for each 1% of the return rate, ¥180 are awarded.
In case of negative returns, resulting losses are subtracted from bonus payment awarded forregular logging on to the experiment homepage described above. 10 The third payment type is a¥30,000 “winner prize” awarded to the participant whose final holdings after the experiment has
ended were the highest.

2.1.3. Basic Experiment Data
Participants were recruited (with the assistance of an internet research company) from amongindividual investors with previous stock trading experience, defined as having recent history of
trading at least once per month on the stock market. The average age was 41.94 years(SD=10.74; For males 41.03, SD＝10.98, for females 44.38, SD=10.06). Attributes of theexperiment participants are summarized in Table 1. The most numerous age groups were people
in their 30s, followed by 40s, with fewer representatives of 60s and 70s. Employment income
earners comprised about half of the pool of subjects. Four of the male participants were businessowners. Household income ranged from 3 million yen to 15 million yen levels. Finally, subjects
reported real-world markets trading frequency was most commonly “roughly once a week” or“almost daily”, either type of responses accounting for over 30% of total.
On January 24th 2010, subjects were gathered together at a computer laboratory on Osaka
University campus and explained thoroughly the experiment. On the same day, the supplemental

9

These bonus payments are: ¥1,800 for logging on between 18 and 22 days, ¥2,600 for logging on
between 23 and 27 days, and ¥3,600 for logging on 28 days (every day of the experiment).
10
Should the resulting yen amount be negative, a concerned subject was to receive ¥0. However, there
were no relevant cases.

10risk aversion estimation experiments elaborated on below and questionnaire survey designed toelicit reference points were conducted. From Monday January 25 th 2010 through Sunday
February 21st 2010, every evening between the hours 18:00 and 22:36 the simulated stock
market was open for trading.

2.2. Loss Aversion Measurement Experiment
The measurements of individual loss aversion levels were carried out by means of two simple
experiments. The “Insurance Buying Experiment” was implemented to estimate individual risk
aversion levels in the loss domain. The “Lottery Selling Experiment” was implemented toestimate risk aversion levels in the gain domain. Both were conducted on Sunday January 24 th2010 – on the same day participants were gathered and explained experiment procedures.

2.2.1. Insurance Buying Experiment
In this experiment, a subject is asked whether they are willing to purchase insurance at various
prices displayed on the monitor. Given an initial endowment of assets, the insurance – ifpurchased – guarantees a payment equivalent to the value of assets in case these are lost or
damaged. This design in effect allows the experimenters to estimate the degree of participants’loss aversion.
The details of the experiment are as follows. A subject is first presented with an initialendowment of ¥2,000. Then, an amount of potential damage and the probability its occurrence
are displayed along with a proposed insurance premium. The subject chooses whether topurchase the insurance or to decline it. There are four categories of potential damage (¥100,

11¥400, ¥1200, ¥2000) with the probability of their occurrence set constant at 50%. The insurance
premiums (along with corresponding premium rates, equal to the premium sum divided by thedamage total) are displayed in random order. An example screenshot is illustrated in Figure 2.
This procedure is repeated 30 times in a row for each category applicable to the four potential
damage totals, starting from the lowest ¥100.
Thus, each subject goes through 120 yes-or-no queries. After that, the computer randomly
chooses one of the 120 queries, which is then used to determine payments for this experiment. 11

2.2.2. Lottery Selling Experiment
Individual levels of risk aversion were estimated via the “Lottery Selling Experiment”. In it, thesubjects are asked whether they are willing to sell at a proposed price a lottery ticket, which has
a 50% chance of winning a prize. The prize falls into one of four categories: ¥100, ¥400, ¥1200,¥2000. A participant’s task is to answer “yes” or “no” to 30 choice problems for each of the four
categories. The procedures as well as settlement of payments are analogous to those employedin the “Insurance Buying Experiment”. 12

2.3. Questionnaire Survey
The survey was conducted mainly to find out reference prices, but we also included in the11

If a subject had in fact purchased insurance for the randomly chosen query, they were given the option
to avert any potential damage by actually paying the premium. In the reverse case when they had notpurchased the insurance, the subject had to pay the amount of damage (in case it occurred), which was
subtracted from their initial endowment. The endowment was left intact whenever no damage actuallyoccurred. Whether the damage in fact occurred or not was selected randomly by the computer withindependent probability of 50%.
12
Out of 120 choice sub-tasks, one was selected randomly by the computer. Had the subject chosen tosell the lottery ticket in that sub-task, they received an amount of money specified therein. In the opposite
case – when the subject had chosen to not sell – the computer drew the lottery and payments were decided
depending upon whether a winning ticket or a losing ticket was drawn. In the former case the subject was
paid the prize, whilst in the latter they received nothing.

12questionnaire items regarding subjects’ preferences and demographic attributes. Here, weconstrain ourselves to the description of our main purpose – identification of individualreference points.
In the questionnaire, hypothetical stock prices paths for two cases – a rising price path and a
declining one – spanning 6 discrete periods are presented. For each respective point in time,
hypothetical buy and sell transactions along with resulting positions in the stock in question are
shown. Furthermore, a 7th period price is shown along with 8 different ways to calculate paper
gains and paper losses for the relevant stock. Subjects are then requested to choose a method of
calculation closest to their own.13 The available choices for a reference point are: (1) the firstpurchase price; (2) FIFO: first-in, first-out; (3) the last purchase price; (4) LIFO: last-in,
first-out; (5) the highest purchase price; (6) the lowest purchase price; (7) weighted averagepurchase price; (8) weighted average purchase price minus average profit/loss for the portion ofshares sold in the interim time.

3. Analysis Method
3.1. Estimating the Degree of Risk Aversion
We restrict our explanation here to the case of Insurance Buying Experiment, wherein we used
computational methods exactly analogical to those used in the Lottery Buying Experiment.
First we compute for all experiment participants their individual insurance values. Whenspecific insurance policies are ordered starting from the cheapest one going in value up to themost expensive one, we would expect to observe any given subject to first choose “buy” for a

13

There is also an additional item corresponding to a “none of the above” option, where a subject is
asked to describe in detail their method of calculation.

13

few times, at some point switch to “sell”, then continue to choose “sell” for the remaining cases.
We define the “individual insurance value” as the midpoint between the two values between
which said switch occurs. It is however conceivable, and indeed turns out to be the case that,some subjects choose to switch multiple times. In these cases, we estimate a LOGIT regression
model for the 30 proposed insurance prices where we assign a “1” to each “buy” decision and a“0” to each “do not buy” decision. The individual insurance value is then defined as the one
corresponding to 0.5 in the regression.
Absolute risk aversion (ARA) coefficient for the ith subject is defined and calculated
according to the following formula due to Cramer et al. (2002).

ARAi 

az  pi1 (az 2  2api z  pi 2 )2(1)Here, a is the probability of winning equal to 0.5, z is the damage amount, and pi is the“individual insurance value”. As there are four different z values, we take an arithmetic averageof those to get the final ARA coefficient values. 14

3.2. The Estimation Model
Estimation of the disposition effect and its potential relationship with loss aversion is performed
with a LOGIT analysis. The dependent variable 𝑆𝐸𝐿𝐿𝑖,𝑗,𝑡 is defined as follows. For eachsubject i we first look for all instances (measured in two-minute units) any trades were recorded.
The subscript t then corresponds to a location of a trade when trades are ordered starting fromthe first one recorded on. 𝑆𝐸𝐿𝐿𝑖,𝑗,𝑡 is set to 1 whenever a subject i sells a stock j at a time t andto 0 otherwise. The independent variable 𝐿𝑂𝑆𝑆𝑖,𝑗,𝑡 is set to 1 whenever a stock j in a subject i's
14

Four subjects in total appeared to either answer Yes/No randomly or reverse the “Yes’s” with the“No’s”. We exclude their data from the regressions.

14

portfolio is trading at a loss at a time t, and to 0 otherwise. The regression model is thus
Model 1：

𝑆𝐸𝐿𝐿𝑖,𝑗,𝑡 = 𝛼 + 𝛽1 ∙ 𝐿𝑂𝑆𝑆𝑖,𝑗,𝑡 + 𝜀𝑖,𝑗,𝑡 ,(2)where 𝛼 and 𝛽1 are the regression coefficients and 𝜀𝑖,𝑗,𝑡 is the error term. 𝛽1 will be
negative if the disposition effect obtains, that is, if the tendency to sell is stronger in the domainof gains than it is in the domain of losses.
Next, we test for loss aversion as a possible cause of the disposition effect. It is plausible thatas the degree of loss aversion increases, disposition effect becomes stronger. The absolute valueof coefficient 𝛽1 from equation (2) in this case increases with the degree of loss aversion LA.
The regression model in this case is thus
Model 2：𝑆𝐸𝐿𝐿𝑖,𝑗,𝑡 = 𝛼 + (𝛽11 + 𝛽12 ∙ 𝐿𝐴𝑖 ) ∙ 𝐿𝑂𝑆𝑆𝑖,𝑗,𝑡 + 𝜀𝑖,𝑗,𝑡= 𝛼 + 𝛽11 ∙ 𝐿𝑂𝑆𝑆𝑖,𝑗,𝑡 + 𝛽12 ∙ 𝐿𝐴𝑖 ∙ 𝐿𝑂𝑆𝑆𝑖,𝑗,𝑡 + 𝜀𝑖,𝑗,𝑡 .

(3)

We expect 𝛽12 to be negative if indeed loss aversion is a cause of the disposition effect. We use
here two variables to represent loss aversion. The first one LA1 is the degree of risk tolerance(the negative of risk aversion) in the domain of losses, which corresponds to a measure ofconvexity of the value function. The second one LA2 is the risk tolerance degree in the domainof losses relative to its counterpart in the domain of gains, defined as risk aversion coefficient in
the domain of gains minus risk aversion coefficient in the domain of losses. This second relative
measure of loss aversion might be a more appropriate one given that the disposition effect itself
is in its nature a relative measure of the extent to which winners are more likely to be sold thanlosers.

4. Results

15

4.1. Reference Points
We use each experiment participant’s individual reference point estimated from thequestionnaire survey data outlined above. Table 2 summarizes our findings on the reference
points: calculated reference points for the domain of gains are in rows, while those for thedomain of losses in columns. For instance, the “1” in the left-uppermost cell of the tableindicates that one person chose the first purchase price for both the gain and the loss domains.
Thus we find most of subjects choosing a weighted average of the purchase prices for theirreference points, many of them profits for the portion of shares sold in the interim. We note thatmost of respondents selected the same reference points for both the loss and the gain domains.

4.2. Results of the Stock Trading ExperimentThroughout 28 days of the experiment and across 49 participants we recorded a total of 3527
sell transactions and 4005 buy transactions – about 153 trades per subject, roughly 5.5 trades per
subject per day. Out of the 10 stocks trades, the most frequently bought and sold one was traded
1639 times, the least popular one 430 times, whilst the corresponding figures for remaining
eights stocks were between 527 and 839. We observe thus an overall abundance of trading
activity, with one stock out-topping all the others in popularity. Out of all sell orders, 1620
(45.9%) were profitable while 1357 (38.5%) were accompanied by losses. The remaining 550(15.6%) trades were zero-profit transactions. For the case of buy orders, 622 (15.58%)
additional purchases were recorded in the gain domain, 1108 (27.7%) additional purchases in
the loss domain, while 2275 (56.8%) additional purchases were recorded on zero-profit
accounts.

16

Final asset value scores, when compared with the initial benchmark of 10,000,000 points,
averaged an approximate 70,000 point loss (SD=34,000), with the highest scoring subject
winning a profit of some 80,000 points and the biggest loser incurring some 88,000 points inlosses.

4.3. Results of the Loss Aversion Measurement Experiment
The average absolute risk aversion coefficient across all subjects was –0.0014 in the Lottery
Selling Experiment, –0.0031 in the Insurance Buying Experiment. The apparent risk loving
attitudes in the domain of gains is perhaps a byproduct of the relatively small stakes used in thesimple lottery tasks we employed to estimate loss aversion attitudes.
When we subtract the risk tolerance coefficient measured in the Lottery Selling Experimentfrom the one measured in the Insurance Buying Experiment, we obtain 0.00168, which issignificant at a 5% level. We conclude therefore that our subjects exhibit more risk-seeking
behavior in the domain of losses as opposed to the domain of gains.

4.4. Incidence of the Disposition Effect – LOGIT Regressions
The summary of LOGIT analysis using individual-specific reference points determined througha questionnaire survey is presented in Table 3. The first panel reports pooled results for all ten
stocks. The “Model 1” section reports estimation results for formula (1). The coefficient for the
loser-stocks variable LOSS is significantly negative at 1% revealing a tendency to avoid therealization of losses. The “Model 2 (1)” section adds the 𝐿𝐴1 ∙ 𝐿𝑂𝑆𝑆 as an explanatory variable
to the regression. Again, the LOSS coefficient is negative at a 1% significance level. Together

17with “Model 1”, this implies reluctance on the part of subjects to get rid of losing stocks andthereby the existence of disposition effect. Furthermore, the coefficient for the 𝐿𝐴1 ∙ 𝐿𝑂𝑆𝑆
variable is also significantly negative at a 1% level. Also for the alternative measure of loss
aversion used in “Model 2 (2)”, the coefficient of interest is negative and statistically significant
at a 1% level. These results support the hypothesis that loss aversion is a cause of the disposition
effect: The higher the degree of loss aversion, the more reluctant investors are to sell losing
stocks.
With the exception of stock #8, we obtain analogical statistically significant results for the
LOSS coefficients when we perform the regressions for individual stocks (not reported here). As
for its interaction term with the loss aversion variable LA1, the coefficients are negative except
for stock #8 and significantly negative except for stocks #8, #1 and #5. When LA2 is substituted
for the loss aversion variable, the interaction term coefficients are negative except for stock #9
and significantly negative except for stocks #3 and #9. Hence we conclude that for most of thecases our results are consistent with the disposition effect hypothesis and that loss aversion is
one of its sources. In other words, these outcomes are not driven by any one of the stocks insubjects’ portfolios but are a prevalent tendency evident throughout the entire stock spectrum.

4.5. Participants’ Demographic and Personal Attributes
In this section we check whether results reported in the previous section are replicated when we
take into account experiment participants’ individual demographic and personal traits. The
particular attributes we include in our analyses are gender, age, household income, and stock
trading experience.

18

Table 4 summarizes the results. In a nutshell: (1) The disposition effect obtains even when
individual attributes are accounted for; (2) The cross-term coefficients for the losing stocks term
LOSS and both loss aversion terms LA1 and LA2 are negative and statistically significant.
Clearly, higher loss aversion produces a more pronounced disposition effect.
A look at the control variables tells us that women are less prone to selling. Also, propensity
to sell grows stronger with both age and income, albeit in a diminishing manner. Finally, thosewith more real-world trading experience tend to sell stocks more frequently.

4.6. Alternative Reference Points
In the analyses reported thus far we used individual-specific reference points elicited from theexperiment participants through a carefully tailored questionnaire survey. It is prudent therefore
to verify whether obtained results are not changed when other, arbitrarily chosen reference
prices are employed. For completeness, we performed this verification exercise for all subjects
for each of the eight reference points specified above in Section 2.3, for both “Model 1” and“Model 2”. The findings do not differ much from the main results reported above. In Table 5 weshow the estimation results for two out of eight reference prices – average purchase price
WAPP1 and first-bought first-sold FIFO. These findings corroborate previous empirical studies
that report robustness of the disposition effect with respect to a variety of assumptions onreference points.

5. Conclusions
The economic experiment reported in this paper adds to a substantial body of work on the19existence of disposition effect and potential causes thereof. While numerous experimental works
do exist on the topic, the distinguishing feature of our approach is the close similarity of ourexperimental environment with real-world stock markets. For a span of 28 days, participants ofour simulated stock market bought and sold shares in 10 stocks whose prices were taken from
actual past market data. Participants’ remuneration was commensurate with profits and losses
incurred from buying and selling stocks. On top of that, a winner’s prize was awarded to themost successful trader. As a result, we acquired ample trading data with a total of 7532
transactions. With all the advantages stemming from similarities of our simulated market withreal-world stock exchanges, the fact that it is not one adds to its merits as it allows theexperimenters to control for a range of conditions. For instance, absence of taxation andtransaction costs eliminates the need to consider their effects. 15
The largest merit of our experiment lies in the fact that we were able to extract two types of
information from the participants. First, we pinpointed each participant’s individual reference
point using a questionnaire survey we conducted before the experiment. This information is
impossible to get in empirical studies and to the best of our knowledge, no previous
experimental studies attempted it, either. Accordingly, we succeeded in testing for an
independent hypothesis for the existence of disposition effect, and not merely for a joint
hypothesis of the disposition effect and a reference point.
Second, we measured participants’ risk aversion attitudes in both domains of gains and losses
in two supplementary experiments – the “Lottery Selling Experiment” and the “Insurance
Buying Experiment” – and used thus obtained results to examine the influence of loss aversion

15

However, we can eliminate neither portfolio rebalancing nor regression to the mean arguments aspotential causes of the disposition effect as we were unable to control for them.

20

on the disposition effect. Loss aversion is a cause of the disposition effect if the latter becomesstronger whenever either (i) behavior in the domain of losses becomes more risk-seeking, or (ii)behavior in the domain of losses compared to behavior in the domain of gains becomes morerisk-seeking.
Our approach has an additional merit over previous studies of being a direct examination ofloss aversion as a potential cause of the disposition effect. Odean (1998) deduces that loss
aversion brings about the disposition effect in an indirect manner – he shows by elimination thatalternative explanations do not account for the disposition effect.
We demonstrate directly with LOGIT regression analyses that the disposition effect exists andthat loss aversion is one of its causes. This result remains valid even when we change thepersonal reference points to any potential reference point including a weighted average ofpurchase prices and FIFO.
In a recent study relevant to the present research, Kaustia (2010) reports simulation resultsthat point to a lack of relationship between loss aversion and the disposition effect. His method
assumes a particular for of the value function proposed by Tversky and Kahnaman (1992) aswell as normally distributed returns in both domains of gains and losses. One might rightly
question then whether it is possible to reconcile our results showing that loss aversion is a causeof the disposition effect with Kaustia’s (2010) findings. We conjecture though that the twoseemingly contradictory findings are not necessarily inconsistent, that being not for reasons
related to differences in measurement targets (Kaustia’s Finland vs. Japan in our case) or
method of investigation (Kaustia’s simulation vs. our experiment). Kaustia’s stylized analysis
relies heavily on three devices: (1) Assuming a particular (albeit typical) form of the value

21

function; (2) Ignoring the probability weighting function; (3) Assuming a specific rate of return
distribution for the entire range of gains and losses combined. Contrastingly, we consider a moregeneral issue of whether the degree of loss aversion impacts the disposition effect without
resorting to prospect theory-related peculiarities. For an instance, with regard to (1), a
rudimentary check for the effects of increased convexity/concavity of the value function iscalled for. Also, concerning (3), it would be instructive to consider a possibility that an investor
trapped in the domain of losses might limit her beliefs about the distribution of future returns tolosses.
Another related study by Barberis and Xiong (2009), which also assumes a parameterized
Tversky and Kahneman’s (1992) value function, reports that resulting behavior should be
opposite to predictions of the disposition effect. Barberis and Xiong’s (2009) method involves
solving a theoretical model and a numerical calibration. Interestingly though, the authors
confirm their results become consistent with the disposition effect once value function isredefined over realized gains and losses, and not paper gains and losses. Since we only consider
realized gains and losses in our paper, Barberis and Xiong’s (2009) findings are a statement tothe consistency of our results with the prospect theory preferences.
These studies point toward a pressing need for further research on the specifications ofprospect theory’s value function that are consistent with the disposition effect. Our results
clearly support value functions based on loss aversion.

22

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Hens, T., and M. Vlcek (2011), “Does Prospect Theory Explain the Disposition Effect" Journalof Behavioral Finance, 12(3), 141–157.
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24

Table 1: Summary of experiment participants’ attributes data.
Participants were recruited (with the assistance of an internet research company) from among individual investors
with previous stock trading experience, defined as having recent history of trading on the stock market at least once
per month.
Malenage_group
20-29
30-39
40-49
50-59
60-69
70TotalJOB
civil servant
business executive
administrative staff
office staff
technical staff
sales/customer service
other salaried worker
teacher
medical expert
self-employedother part-time
homemaker
working homemaker
unemployed
other
Total
INCOME_GROUP (unit: 10,000yen)<100
100-200
200-300
300-400
400-500
500-600
600-700
700-800
800-900
900-1000
1000-1500
1500unknown
Total
FREQ_TRADE (about once in ~)a monthhalf a montha week
daily
Total

%

Female
%

n

Total
%

n

3
16
9
5
0
2
35

8.60%
45.70%
25.70%
14.30%
0.00%
5.70%
100.00%

1
4
5
1
2
0
13

7.70%
30.80%
38.50%
7.70%
15.40%
0.00%
100.00%

4
20
14
6
2
2
48

8.30%
41.70%
29.20%
12.50%
4.20%
4.20%
100.00%

1
2
1
2
10
4
2
1
1
4
2
1
0
1
3
35

2.90%
5.70%
2.90%
5.70%
28.60%
11.40%
5.70%
2.90%
2.90%
11.40%
5.70%
2.90%
0.00%
2.90%
8.60%
100.00%

0
1
0
3
0
2
0
0
0
0
0
4
2
1
0
13

0.00%
7.70%
0.00%
23.10%
0.00%
15.40%
0.00%
0.00%
0.00%
0.00%
0.00%
30.80%
15.40%
7.70%
0.00%
100.00%

1
3
1
5
10
6
2
1
1
4
2
5
2
2
3
48

2.10%
6.30%
2.10%
10.40%
20.80%
12.50%
4.20%
2.10%
2.10%
8.30%
4.20%
10.40%
4.20%
4.20%
6.30%
100.00%

1
0
1
3
5
5
5
2
6
4
1
1
1
35

2.90%
0.00%
2.90%
8.60%
14.30%
14.30%
14.30%
5.70%
17.10%
11.40%
2.90%
2.90%
2.90%
100.00%

0
1
0
2
1
3
0
2
0
1
0
3
0
13

0.00%
7.70%
0.00%
15.40%
7.70%
23.10%
0.00%
15.40%
0.00%
7.70%
0.00%
23.10%
0.00%
100.00%

1
1
1
5
6
8
5
4
6
5
1
4
1
48

2.10%
2.10%
2.10%
10.40%
12.50%
16.70%
10.40%
8.30%
12.50%
10.40%
2.10%
8.30%
2.10%
100.00%

9
2
11
13
35

25.70%
5.70%
31.40%
37.10%
100.00%

0
6
5
2
13

0.00%
46.20%
38.50%
15.40%
100.00%

9
8
16
15
48

18.80%
16.70%
33.30%
31.30%
100.00%25

Table 2: Questionnaire Survey of Reference Points – Summary of Results.
This table summarizes the results of a questionnaire survey conducted to elicit individual reference points. It reports
the number of subjects corresponding to each combination of reference points. Each row represents a reference point
for the domain of gains and each column represents a corresponding reference point for the domain of losses. The
labels for each reference point are as follows. FIRST: first purchase price; FIFO: first-in first-out; LAST: lastpurchase price; LIFO: last-in first-out; HIGH: highest purchase price; LOW: lowest purchase price; WA1: weighted
average purchase price; WA2: weighted average purchase price minus average profit/loss for the portion of shares
sold in the interim time NULL: no response.

FIRST
FIFO
G
LAST
A
LOW
I
WA1
N
WA2
OTHER
TOTAL

FIRST FIFO
1
2
2

LAST

LIFO

LOSS
LOW WA1

1
1

1

4

1

1

2

1

15

1

26

1
16

WA2 OTHER NULL TOTAL
1
1
3
3
1
1
1
19
21
21
1
22
1
1
49

Table 3: Summary of LOGIT Regressions Using Individual-Specific Reference Points
This table shows regression results for two models – “Model 1” and “Model 2”. Data for this analysis consists oftrade records for all the stocks in subjects’ portfolios. The dependent variable SELL takes the value of 1 whenever asell transaction occurs, and 0 otherwise. The variable LOSS is set equal to 1 whenever a stock is trading at a loss and0 otherwise. Whether the stock in question is actually trading at a loss is determined via a subject-specific reference
point elicited through a questionnaire survey. Whenever such determination was not possible, corresponding data was
excluded from analysis. Loss aversion coefficients LA1 and LA2 used for Model 2 (1) and Model 2 (2) are defined as
LA1 = (–1) * (Degree of Risk Aversion in the Insurance Buying Experiment) and LA2 = (–1) * (Degree of Risk
Aversion in the Insurance Buying Experiment) – (–1) * (Degree of Risk Aversion in the Lottery Selling Experiment),
respectively. *** indicates coefficients which are significant at the 1% significance level.

Model 1Model 2
(1)

coef.
LOSS

-0.75

z
-19.64 ***LA1･LOSS

coef.

z

-0.53

-10.39 ***-58.27-6.23 ***

LA2･LOSS
Constant-1.15-46.07 ***-1.15-46.07 ***

(2)
coef.

z

-0.55

-13.10 ***-46.19-9.13 ***

-1.15

-46.07 ***Pseudo R2

0.02

0.02

0.03

Number of
Observations

19451

19451

19451

Marginal
Effects
LOSS
LA1

-0.11

-19.91 ***-0.11-19.60 ***-3.61-6.23 ***

LA2

27

-0.11

-19.53 ***-2.85-9.11 ***

Table 4: Summary of LOGIT Regressions Including Individual Attributes
This table reports results of regressions for “Model 1” and “Model 2” with experiment subjects’ personal attributes
added as independent variables. The dependent variable SELL takes the value of 1 whenever a sell transaction occurs,and 0 otherwise. The variable LOSS is set equal to 1 whenever a stock is trading at a loss and 0 otherwise. Whether
the stock in question is actually trading at a loss is determined via a subject-specific reference point elicited through aquestionnaire survey. Whenever such determination was not possible, corresponding data was excluded from analysis.
FEMALE is a dummy variable equal to 1 for females and 0 for males, AGE is the age variable and INCOME is theincome variable. FREQ_TRADE_dummy is the dummy variable with values assigned according to subjects’
real-world market trading experience. Loss aversion coefficients LA1 and LA2 used for Model 2 (1) and Model 2 (2)are defined as LA1 = (–1) * (Degree of Risk Aversion in the Insurance Buying Experiment) and LA2 = (–1) * (Degreeof Risk Aversion in the Insurance Buying Experiment) – (–1) * (Degree of Risk Aversion in the Lottery Selling
Experiment), respectively. **, *** indicate coefficients which are significant at the 5% and 1% significance level,
respectively.

Model 1Model 2
(1)

LOSS
LA1･LOSS
LA2･LOSS

coef.
-0.719z-18.30 ***coef.
-0.608-31.804(2)

z-11.28 ***-2.95 ***

coef.
-0.604z-13.68 ***-29.091-5.36 ***FEMALE-0.726-13.64***-0.660-11.44***-0.672-12.55***AGE(x0.01)

5.164

3.66

***

4.459

3.12

***

0.045

3.21

***

AGE (x0.0001)-6.851-4.81***-6.155-4.27***-5.975-4.21***

INCOME(x0.01)-0.127-10.77***-0.124-10.46***-0.115-9.66***

INCOME2(x0.0001)

0.001

11.10

***

0.001

10.84

***

0.001

10.14

***

2

FREQ_TRADE_dummy(against "once/month")(against "once/month")(against "once/month")

once in half a month-0.804-8.15***-0.827-8.34***-0.833-8.44***

once a week

-0.454-6.01***-0.487-6.39***-0.456

-6.09

***

daily

-0.011-0.16-0.013

-0.20

0.018

0.28

Constant-0.842-2.59-0.693-2.11-0.813

-2.53

***

**

2

Pseudo R

0.063

0.064

0.065

Number of Observations

19345

19345

19345

Model 1Model 2
(1)

Marginal Effects
LOSS

coef.

z

-0.099-18.61

***

***

LA1

(2)

coef.

z

-0.099-18.55***-1.880

-2.96

***

LA2

coef.

z

-0.098-18.46***-1.714-5.37***

FEMALE-0.100-13.74***-0.091-11.50***-0.092-12.62***AGE(x0.01)-0.148-5.58***-0.157-5.89***-0.130-4.89***-0.016-10.72***-0.015-10.39***-0.014-9.58***

INCOME(x0.01)
FREQ_TRADE_dummy(against "once/month")(against "once/month")(against "once/month")

once in half a month-0.111-8.17***-0.114-8.36***-0.115-8.46***

once a week

-0.062-6.02***-0.067-6.41***-0.063

-6.10

***

daily

-0.001-0.16-0.002

-0.20

0.003

0.28

28

Table 5: LOGIT Regressions Results Summary under Weighted Average Purchase Price WAPP1
and under the First-Bought First-Sold FIFO rule as the Reference Point
Panels A and B report regression results for “Model 1” and “Model 2” for the case when individual-specific reference
points are replaced with the weighted average purchase price and the first-bought first-sold FIFO rule (i.e. shares
which are purchased first are also sold first) as a reference point, respectively. The distinction between the domain ofgains and the domain of losses is accordingly revised to reflect this change in the reference point. For details, pleaserefer back to Table 3.

Panel A: Weighted Average Purchase Price WAPP1
Model 1LOSS
LA1･LOSS
LA2･LOSS
Constant
Pseudo R2
Number of
Observations
Marginal Effects
LOSS
LA1
LA2

coef.
-0.79

z
-21.01 ***-1.13-45.68 ***0.02

Model 2
(1)
(2)
coef.
z
coef.
z
-0.55 -10.87 ***-0.59 -14.20 ***-63.23-6.83 ***
-47.88-9.51 ***
-1.13 -45.68 ***-1.13 -45.68 ***
0.03
0.03

19992
coef.
-0.11419992

z-21.34 ***coef.
-0.111-3.908z-20.93 ***-6.82 ***

Panel B: the First-Bought First-Sold FIFO
Model 1LOSS
LA1･LOSS
LA2･LOSS
Constant
Pseudo R2
Number of
Observations
Marginal Effects
LOSS
LA1
LA2

coef.
-0.79

-1.15

coef.
-0.112z-20.94 ***-2.948-9.48 ***

Model 2z
-20.93 ***

coef.
-0.51
-74.42-46.96 ***
0.02

-1.15

19992
coef.
-0.114

19992

(1)
z
-10.10 ***-7.94 ***
-46.96 ***
0.03

coef.
-0.58
-53.29
-1.15

19992

z
-21.25 ***coef.
-0.111-4.40029

z-20.79 ***-7.92 ***

(2)z
-13.94 ***-10.28 ***-46.96 ***
0.03
19992

coef.
-0.113z-20.99 ***-3.138-10.23 ***Figure 1: A screenshot of a transaction panel (translated from Japanese).
The screenshot in figure above provides information on the present composition of the subjects’ portfolios, stock
prices and cash holdings. Subjects use it also to order their buy and sell transactions, which are immediately executed.
For instance, by changing the number of shares in the “After Transaction” column and clicking on “Trade”, acorresponding order is completed.

30

Figure 2: A screenshot from the “Insurance Buying Experiment” (edited from Japanese).
The display for this experiment shows an amount of potential damage with the probability of its occurrence as well as
an insurance premium offer. The subject chooses either to purchase the insurance (”yes”) or to decline it (”no”).

31