Investor Behavior: Part I

This purpose of this post is to share with you what I considered some interesting information about individual investors. The paper is from Advances in Behavioral Finance, Vol II, Russell Sage Foundations/Princeton University Press, 2005. This post will be in two parts.

The paper is Chapter 15 of the aforementioned book and is titled, "Individual Investors", its authors, Brad M. Barber and Terrance Odean. If this is a subject that interests you, though the paper is not listed at this following link, several other papers are listed that you might find interesting. In this paper, the authors examine "The Disposition Effect" (explained below) and investors' tendencies to trade to frequently due to overconfidence.

Before getting started with some of the concepts of the paper, there are two investor theories that you should understand. First, there is the Disposition Effect. Simply put, the Disposition Effect describes an investor's tendency to sell his/her winner while hanging onto his/her losers. It's the reason of for the aphorism: sell your losers and let your winners runs. Seems like reasonable enough counsel, but it is counter to the behavior that most investors exhibit. The stain of shame is on my cheek for this behavior as well.

Second, is Prospect Theory (PT): You can find a comprehensive explanation here. Essentially, PT serves as a counter to the rational behavioral models that economists build that assume people are rational. PT is observed behavior that is NOT rational, and describes that that "many people are far more willing to engage in risky behavior to avoid potential losses than they are willing to take risks to improve their positions."(cited from link). Do visit the link and read the information. It is not even a page, and it will flesh out this rater meager morsel of an introduction here.

The Disposition Effect:





The above represents the value function. It relates to an investor's perception of expected gains/losses. "Critical to this value function is the reference point from which gains and losses are measured." (p. 544). Here the reference point could be the purchase price, the current price, or some expectation of value. The authors quote Kahneman and Tversky 1979, p. 287): "there are situation in which gains and losses are coded relative to an expectation or aspiration level that differs from the status quot. . . A person who has not made peace with his losses is likely to accept gambes that would be unacceptable to him otherwise."

To sell a stock that has appreciated, the investor has to lower his/her expectation of the stock's ultimate value. Now the stock has declined. The authors state, "Then its price is in the convex, risk-seeking, part of the value function. [L's note: lower left quad] Here the investor will continue to hold the stock even it its expected return falls lower than would have been necessary for her to justify its original purchase. Thus the investor's belief about expected return must fall further to motivate the sale of a stock that has already declined rather than one that has appreciated." (p. 544). If an investor has a liquidity issue and has two stock's--one depreciated, one appreciated--without any new information regarding either stock, the investor "is more likely to sell the stock that is up." (p. 544).

So if you find yourself doing this recalibration of expectations for a stock, and you have a different standard for expectations of continuing gains for your winners vs. expectations of continuing losses for you losers, then you are in good company. Just remember, your expectations have been empirically proved wrong! The authors then go into the study design which I'll summarize briefly:

• Data was gathered from 78K households over a 5 year period (1991-1996). It's worth noting that ease of trading and trading expense has changed dramatically since that time period. It would be interesting to see if the author's original test results still stand in the same proportions as noted in the next bullet.

• Computed Percentage Gain Realized (PGR) on all appreciated stock v. Percentage of Loss Realized (PLR) on all depreciating stock. The authors found that "During this sample period, stocks that hand increased in value were approximately 65 percent more likely to be sold than stocks that had declined in value." (p. 548)The authors point out a number of potential reasons as to why investors were reluctant to sell their losers. They note that other studies fail to denote the distinctions as to why investors sells losers rather than winners. Here's a brief summary:
  

• Anticipations of Changes in Tax Law: The authors found no effect.
  
• Desire to Rebalance: No difference. When study modified to take this into consideration, they still found that investors prefer to sell winners.
• Belief that One's Losers Will Bounce Back: Compared to the sold winners, the investors were mistaken.
• Attempt to Limit Transaction Costs. Nope again.
• Belief that all Stocks Mean Revert. Given the importance of this, I'm going to quote directly from the paper: "The results. . . are not able to distinguish prospect theory and the mistaken belief that losers will bounce back to outperform current winners. Both prospect theory and a belief in mean-reversion predict that investors will hold their losers too long and sell their winners too soon. Both predict that investors will purchase more additional shares of losers than of winners. However, a belief in mean-reversion should apply to stocks that an investor does not already own as well as those she does, but prospect theory applies only to the stocks she owns. Thus, a belief in mean-reversion implies that investors will tend to buy stocks that had previously declined even if they do not already own these stocks, while prospect theory makes no prediction in this case." P 551-552).
• I've elected not to include
• Employee Stock Options
• Finnish Investors
• Real Estate

In Part II, I will share the authors' view of Investor Overconfidence. I'm not even closed to qualified to addressing questions, but I know that Russell is well-read on this stuff and I'm confident he will help in this regard.