Looking for Someone to Blame: Delegation, Cognitive Dissonance, and the Disposition Effect

• Author: DAVID H. SOLOMON,TOM Y. CHANG,MARK M. WESTERFIELD
• DOI: http://doi.org/10.1111/jofi.12311
• Date: 01 February 2016
• Published date: 01 February 2016

THE JOURNAL OF FINANCE •VOL. LXXI, NO. 1 •FEBRUARY 2016

Looking for Someone to Blame: Delegation,

Cognitive Dissonance, and the Disposition Effect

TOM Y. CHANG,∗DAVID H. SOLOMON, and MARK M. WESTERFIELD

ABSTRACT

We analyze brokerage data and an experiment to test a cognitive dissonance based

theory of trading: investors avoid realizing losses because they dislike admitting that

past purchases were mistakes, but delegation reverses this effect by allowing the in-

vestor to blame the manager instead. Using individual trading data, we show that the

disposition effect—the propensity to realize past gains more than past losses—applies

only to nondelegated assets like individual stocks; delegated assets, like mutual funds,

exhibit a robust reverse-disposition effect. In an experiment, we show that increasing

investors’ cognitive dissonance results in both a larger disposition effect in stocks

and a larger reverse-disposition effect in funds. Additionally, increasing the salience

of delegation increases the reverse-disposition effect in funds. Cognitive dissonance

provides a unified explanation for apparently contradictory investor behavior across

asset classes and has implications for personal investment decisions, mutual fund

management, and intermediation.

IN RECENT YEARS,ECONOMISTS have come to appreciate the importance of house-

hold investment decisions for understanding both decision-making under risk

and the behavior of investors in financial markets (e.g., Campbell (2006)). One

of the most robust facts describing individual trading behavior is the disposition

effect: investors have a greater propensity to sell assets when they are at a gain

than when they are at a loss (Shefrin and Statman (1985)).1Despite the near-

ubiquity of the disposition effect, however, the underlying mechanism is not

∗Chang and Solomon are with the University of Southern California, and Westerfield is with

the University of Washington. We would like to thank Nick Barberis, Zahi Ben-David, Ekaterina

Chernobai, Bill Christie, Lucas Coffman, Harry DeAngelo, Wayne Ferson, Cary Frydman, Mark

Grinblatt, Jarrad Harford, David Hirshleifer,Markku Kaustia, Kevin Murphy, Ed Rice, Antoinette

Schoar, and seminar and conference participants at the Behavioral Economics Annual Meeting,

CCFC, WFA,Cal Poly Pomona, Emory, Northwestern University,Notre Dame, UC Berkeley, UCSB,

UCSD Rady, University of Oregon, University of Washington, University of Wisconsin Madison,

and USC for helpful comments and suggestions. We especially thank TerryOdean for sharing the

individual trading data. The authors do not have any potential conflicts of interest, as defined in

the JF Disclosure Policy.

1Across asset markets, the disposition effect has been documented in stocks (Odean (1998)),

executive stock options (Heath, Huddart, and Lang (1999)), real estate (Genesove and Mayer

(2001)), and online betting (Hartzmark and Solomon (2012)). Across investor types it has been

found among futures traders (Locke and Mann (2005)), mutual fund managers (Frazzini (2006)),

and individual investors (for the United States, Odean (1998); Finland, Grinblatt and Keloharju

(2001); China, Feng and Seasholes (2005)).

DOI: 10.1111/jofi.12311

267

268 The Journal of Finance R

well understood. Empirical work has been much more successful in identifying

problems with various proposed explanations than in finding positive evidence

that points directly to a particular theory to the exclusion of all others.2

In an apparently puzzling contrast, the disposition effect is reversed in mu-

tual funds, as investors have a greater propensity to sell losing funds compared

to winning funds. This fact has been known at least since Friend, Blume, and

Crockett (1970), but has been discussed primarily in the context of the positive

performance-flow relationship (e.g., Chevalier and Ellison (1997)): funds that

exhibit high returns receive greater inflows, while those with low returns re-

ceive greater outflows. Importantly, this finding holds for flows from existing

investors as well as new investors (Ivkovi´

c and Weisbenner (2009) and Calvet,

Campbell, and Sodini (2009)). With a few exceptions (e.g., Kaustia (2010a)), the

positive performance-flow relationship has not been thought of as equivalent to

a reverse-disposition effect, and has received little discussion in the literature

that seeks to understand what drives the disposition effect.

In this paper, we examine cognitive dissonance as a parsimonious model

for understanding variation in the disposition effect both within and across

asset classes. We begin by describing the psychological theory of cognitive

dissonance—formalized by a three-period trading model in the Internet

Appendix3—demonstrating how cognitive dissonance can generate a dis-

position effect in nondelegated assets like stocks but a reverse-disposition

effect in delegated assets like mutual funds. We then analyze data from

individual trading accounts and an experiment, and provide positive evidence

in favor of cognitive dissonance as a driver of the disposition effect. We also

show that several broad classes of existing theories—such as rational and

semirational learning models, purely returns-based preferences, and variation

in risk attitudes—are insufficient to explain our results. Finally, we provide

direct empirical evidence of the role of cognitive dissonance in generating a

disposition (and reverse-disposition) effect from an online trading experiment.

Cognitive dissonance is defined as the discomfort that arises when a person

recognizes that he or she makes choices and/or holds beliefs that are inconsis-

tent with each other (Festinger (1957)). This discomfort is particularly acute

when one of the beliefs in question relates to the individual’s self-concept (e.g.,

Gecas (1982)). We argue that investors feel a cognitive dissonance discomfort

when faced with losses—there is a disconnect between the belief that the

investor makes good decisions and the fact that the investor has now lost

money on the position. While all losses cause such dissonance, realized losses

create a greater level of discomfort than paper losses: when the loss exists only

on paper the investor is able to partly resolve the dissonance by convincing

themselves that the loss is only a temporary setback. This reduces the blow

to their self-image of being someone who makes good decisions. When the loss

is realized, it becomes permanent, which makes it harder for the investor to

2See the discussion in Sections III.D and IV.

3The Internet Appendix is available in the online version of the article on the Journal of Finance

website.

Looking for Someone to Blame 269

avoid the view that buying the share may have been a mistake. Cognitive

dissonance provides the basis for an overall reluctance to realize losses, and

thus generates a wedge relative to the investor’s propensity to realize gains

(where no such dissonance discomfort exists).

An important difference arises in the case of delegated assets, where

decision-making authority has been ceded to an outside agent. For these

assets, investors can instead resolve the disutility of realized losses by scape-

goating and blaming the manager. Specifically, if the asset is delegated, then

the investor can blame the fund manager for the poor performance and sell the

asset without admitting to his or her own mistakes. At its simplest level, the

model captures the intuition that investors do not like to admit that they were

wrong, and will blame someone else to avoid admitting a mistake if they can.4

Our first contribution is to empirically document the scope of the puzzle:

how much does the disposition effect vary across asset classes? In individual

trading data (the data set used in Barber and Odean (2000)), we show that

the disposition effect in stocks and the reverse-disposition effect in actively

managed funds holds for the same investors at the same time. In contrast,

investors in passively managed funds (e.g., index funds), where the role of

the portfolio manager is minimal, exhibit a small but directionally positive

disposition effect that is significantly different from actively managed funds

but not from stocks. Looking across a broad range of asset classes (including

options, warrants, bond funds, real estate trusts, etc.), we find that the level

of the disposition effect is almost rank-ordered with delegation, and the effect

of delegation survives controlling for other asset class characteristics such as

volatility, holding period, and position size. In addition, the variation across

asset classes is driven by differences in the propensity to sell losses. This is

consistent with the predictions of cognitive dissonance, since it is only in the

loss domain that there is a dissonance to be resolved.

Existing literature focuses on understanding the disposition effect in gen-

eral, but does not provide a ready explanation for the variation across asset

classes. Because the variation in trading behavior across asset classes exists

even among investors that hold multiple asset classes, the variation is unlikely

to be due to clientele-based explanations, such as investors in each asset class

having different preferences over returns or risk. If the disposition effect is

driven purely by preferences over returns (e.g., prospect theory, realization

utility), some other factor must be invoked to explain its nonexistence in funds.

Our second contribution is to provide direct, positive evidence of the role

of cognitive dissonance in generating the disposition effect. In particular, we

4The experimental literature on delegation and blame documents that principals blame agents

for bad outcomes (see, for example, Hamman, Loewenstein, and Weber (2010) and Bartling and

Fischbacher (2012), and the discussion in Section I). The idea that delegation is useful because

it provides someone to blame for poor performance is similar in spirit to the idea in Lakonishok,

Shleifer, and Vishny (1992, p. 342) that part of the appeal of external management of pension

funds is the result of a desire by the Treasurer’s office “to delegate money management in order to

reduce its responsibility for potentially poor performance of the plan’s assets.” See Barberis (2011)

for a discussion of cognitive dissonance in the context of bank losses during the financial crisis.