The Disposition Effect and Underreaction to Private Information

Abstract We examine the role of the disposition effect in market efficiency following the arrival of private signals to a small group of informed traders. Subjects trade an ambiguous asset via a computer-based double auction. Using a 2 × 2 × 2 design, we endow two types of signal, i.e., positive vs. negative, to informed traders with two different levels of the disposition effect, i.e., high vs. low, that are measured in two domains, i.e., gain vs. loss. We find that (1) the disposition effect measured in the gain domain has qualitatively different implications from the disposition effect measured in the loss domain; (2) following a favorable signal, informed traders with high disposition effect levels are more likely to sell and less likely to hold the asset while following an unfavorable signal, the opposite is true; (3) there is some evidence of stronger price underreaction in markets with informed traders with high disposition effect levels than in markets with informed traders with low disposition effect levels, but the effect is overall relatively weak; and finally and most importantly (4) the above results hold only when the sign of the signal matches the domain that the disposition effect levels of the informed traders are measured in.