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It is not a good comparison when I compare an effect and a trading strategy. However, I see the meaning fo these two concepts are quite similar.

Disposition effect is that "the tendency of investors to sell assets that have increased in value, while keeping assets that have dropped in value"

While contrarian trading strategy is that the investors buy the dropped-value stock and sell the increased-valued stocks. I am wondering what is the notable difference between these two concepts?

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    $\begingroup$ Hi Louise, it seems you are doing research or a master thesis on this topic? Regarding your question: i'm not too familiar with contrarian trading strategies but regarding the disposition effect and the difference to the former, there are a few things to point out: An investor showing the DE will not increase his position if he is in the domain of losses where in contrast the CTS probably will. The motivation is also different: The DE is most likely driven by time-inconsistent dynamic optimization and alternative preferences where CTS may be driven by belief in Mean-Reversion.. does this help? $\endgroup$
    – T123
    Nov 5, 2021 at 9:44
  • $\begingroup$ It makes sense and clear, thanks a heap, T123J $\endgroup$ Nov 5, 2021 at 11:03

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There is a difference in point of view.

"Disposition effect" is used in behavioral finance to discuss the empirical behavior of actual investors who own several stocks: which of these stocks are they more likely to sell. If they tend to sell those that have gone up, rather than based on other criteria (bad earnings report? downgraded by analysts? tax motives? etc.) we say they show "disposition effect". Often the studies are not very clear what the alternative unbiased criteria would be, they just show there is a bias in this direction.

Contrarian trading strategy is a more general term that is not concerned with the specific stocks an investor owns at a given time. The investor reviews a large number of stocks (whether they own them or not) and uses past return over a period of time to judge whether to buy or sell. They like to buy those that have gone down over an appropriate interval and sell those that have gone up.

Disposition effect is highly personal. The behavior depends on what price you bought the stock, and whether you personally experienced paper losses (painful) or gains (enjoyable). You could say that "disposition effect" investors act as if they are following a contrarian strategy, but it is a strange one because they believe the price at which they bought is the important level to use in making decisions. They become fixated on their original entry point. Contrarian strategies are broader than this.

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In addition to what noob2 already posted and what i remarked in the comments i wrote a quick model for the Disposition Effect according to Kaustia (2010) in Excel VBA and simulated the trading pattern of an individual investor for 2 years with 100 stocks for each combination of risk preference parameters under prospect theory https://www.cambridge.org/core/journals/journal-of-financial-and-quantitative-analysis/article/abs/prospect-theory-and-the-disposition-effect/C606F8F6AD493D7E43481C484200A51E: enter image description here

An investor who shows the disposition effect will never increase the position in a stock if it falls below the purchase price, however, a contrarian investor probably will tend to increase his exposure. Note that market parameters are fixed and arbitrary.

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