Human vs. Machine: Disposition Effect Among Algorithmic and Human Day-traders

• BSE Working Paper: 1133 | December 19
• Keywords: rationality , financial markets , automation , disposition effect , algorithmic trading
• JEL codes: D8, D91, G11, G12, G23, G41, O3
• rationality
• financial markets
• automation
• disposition effect
• algorithmic trading

Can humans achieve rationality, as defined by the expected utility theory, by automating their decision making? We use millisecond-stamped transaction-level data from the Copenhagen Stock Exchange to estimate the disposition effect – the tendency to sell winning but not losing stocks – among algorithmic and human professional day-traders. We find that: (1) the disposition effect is substantial among humans but virtually zero among algorithms; (2) this difference is not fully explained by rational explanations and is, at least partially, attributed to prospect theory, realization utility and beliefs in mean-reversion; (3) the disposition effect harms trading performance, which further deems such behavior irrational.