Lesson 10 of 25 · 7 min

The disposition effect, applied to a pledged account

Selling the winners and keeping the losers rearranges an account into exactly the holdings a lender discounts most.

The disposition effect is the tendency to realise gains readily and defer losses. It is loss aversion applied to the decision of what to sell, and it has an ordinary explanation: a sale at a gain closes an episode as a success, and a sale at a loss closes it as a failure.

In an unpledged account the effect shows up mainly in tax and in returns. In a pledged account it does something additional, because the composition of the account determines its blended advance rate, and the holdings most likely to be kept are the ones whose prices have behaved worst. Price behaviour is exactly what an advance rate is set from.

Take four holdings: $420,000 at a 70 percent advance rate, $310,000 at 65 percent, $265,000 at 50 percent and $190,000 at 40 percent. Market value is $1,185,000 and lending value is $294,000 + $201,500 + $132,500 + $76,000 = $704,000, a blended rate of $704,000 ÷ $1,185,000 = 59.4 percent.

Two years later the account is still worth $1,185,000, but the two highest-rated holdings have been realised and the proceeds have gone into positions resembling what was kept: $505,000 at 50 percent, $390,000 at 40 percent and $290,000 at 45 percent. Lending value is $252,500 + $156,000 + $130,500 = $539,000, a blended rate of 45.5 percent. Capacity has fallen $165,000, or 23.4 percent, with the market value unchanged to the dollar.

A balance of $470,000 that stood at $470,000 ÷ $704,000 = 66.8 percent of lending value now stands at $470,000 ÷ $539,000 = 87.2 percent of it. No money was borrowed and no price moved. The account was simply sorted, over two years, by a rule that favours the holdings a lender likes least.

Key terms

Disposition effect: Realising holdings that are up and retaining holdings that are down, independently of what either is expected to do next.
Blended advance rate: Total lending value divided by total market value. It moves when the mix of holdings changes, even if the total does not.
Composition drift: A slow change in what an account is made of, produced by a repeated selection rule rather than by any single decision.

Worked example

Same market value, two years apart

An account of $1,185,000 at both dates, with different holdings at different advance rates. Balance $470,000 throughout.

Lending value at the start: $704,000
Blended advance rate at the start: 59.4%
Lending value two years later: $539,000
Blended advance rate two years later: 45.5%
Capacity lost: $165,000
Balance as a share of lending value: 66.8% to 87.2%

The account is worth exactly what it was worth and supports 23.4 percent less borrowing. The selection rule did all of it.

Check yourself

An account holds $1,185,000 at a 59.4 percent blended advance rate. Two years later it holds $1,185,000 at 45.5 percent. Nothing was withdrawn. What happened?

Saved in this browser only. No account, nothing sent anywhere.

Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.