Lecture 4-Disposition effect, pride and regret Flashcards
Importance of emotion in financial decisions
Agents may make decisions because they have
emotions about possible future emotions
• Specifically, fear of a negative emotion, or hope for
a positive emotion, may influence behaviour
• Fear of regret is argued to drive certain financial
decisions. An investor might regret having made a
bad investment
Example of the importance of emotion in market events
-As financial decisions involve huge stakes
-It was found that reporting significant correlation between market events and
physiological characteristics such as cardiovascular data
80 traders study in relation to emotion
A study looked at 80 day traders
- Tracked their daily emotional state
- And their trading profits and losses
• Those whose emotional reaction to gains and losses
was most intense had the worst trading performance
What is the difference between emotion and mood?
An emotion is about something,
-whereas a mood
is a general feeling that does not focus on anything in particular
What is affect?
Affect is how a person experiences a feeling
Somebody’s affective assessment is experience
they has in response to a stimulus
-Can say whether a stimulus is good or bad, positive or negative
Evolutionary theory in relation to emotion?
- Traits contributing to the survival of species that have become characteristics in the long run
- Emotions have evolved to promote survival of species which are adaptive as they lead to action and communication to others
e. g. get away when danger leads to fear
What parts of the brain are important in investment decisions?
- Limbic system (seat of emotion)
* Forebrain (seat of cognition)
How is emotion not always bad?
It can improve decision-making in two respects:
Emotion pushes individuals to make some decision
when making a decision is paramount
• Often a decision has to be made
Emotion can assist in making optimal decisions
• Positive feelings can make it easier to access
information in the brain, promote creativity, improve
problem solving, enhance negotiation.
The impact of emotion financial decision-making
May be behind disposition effect: tendency to sell
winners too early and hold on to losers too long
• Fear of regret may be driver
-May favor investment in some firms or industries but
not others
• Emotion induced by the stimulus of considering a given
industry is highly correlated with the probability a
participant would choose to invest in that industry
What is regret?
• Regret is a negative emotion
-feel sad, repentant, or disappointed over (something that one has done or failed to do
Example of regret
For example, you might regret a bad investment decision
and wish that you made a different decision
-Your negative feelings are only amplified if you have to
report a loss to someone
What is pride
-is a positive emotion from realising that a
decision turned out well\
-You probably would not mind too much if it just slipped
out in conversation that you made a good profit on a
trade
What is regret aversion?
In relation to blackjack if you have 14 and the dealer has 9, you would feel regret if you hit and went bust
-However, regret aversion is taking action and losing feels worse than “doing nothing” and losing
-Although the outcome is the same, regret
plays a larger role post-action
What is regret omission?
- Not acting on something e.g. not changing your lottery numbers even those number couldve won
- Regret of commision by changing your numbers and you didnt win
- Regret of commission is stronger
The strength and weakness of feeling regret
The feeling of regret is strong if it is clear that you
made a bad choice
• You pick one company and its price declines while the
other firms in the industry rise
-The feeling of regret is weak if it is clear that the
ramifications of the choice were out of your control
• Your stock declines in a general marker decline
Avoiding regret
People avoid actions that create regret
• People seek actions that create pride
What is the disposition effect (Shefrin and Statman 1985)?
Fearing regret and seeking pride causes investors to
be pre-disposed to selling winners too early and
riding losers too long
(Odean 1998) evidence for disposition effect
Trades in 10,000 brokerage accounts with almost
100,000 transactions during 1987-1993 show that:
➢ Investors are 50% more likely to sell a winner than a
loser
➢ The winner stock sold ends up beating the market over
the next year by an average 2.35%
➢ The loser stocks that the investors kept under-performed
the market by –1.06%
-Used reference point of the purchase price for each security
Proportion of gains (losses) realised (PGR) formula
Realised gains/Realised losses + Paper losses
Test for disposition effect using the PGR
-If the proportion of gains realised should exceed proportion of losses realised which was true for Odeans study
What is ‘Paper profits’?
is an increase/decrease in the value of the asset that is not yet sold for cash.
How is disposition effect related with prospect theory and mental accounting?
Disposition effect is reinforced by the tendency for
many investors to treat ‘paper losses’ differently to
realised losses. While the position is still held prices
could rise, when it is sold the loss is confirmed
Mental accounting in relation to the disposition effect
• When the investor first bought a stock she opened a
mental account and keeps a running score of gains and
losses for her investment position
• If for instance, the investor suffers a paper loss and if
she sells the stock the mental account is closed and the
loss becomes certain
Prospect theory and disposition effect
Selling an investment at a profit validates the
decision to buy, and produces a feeling of pride increasing utility
• Hence prospect theory suggest that investors prefer
to sell investments whose prices have risen rather
than those whose prices have fallen
Evidence by Ferris et al (1987) on the disposition effect
Studied disposition effect on market
by analysing volume following price change
• They investigated 30 small stocks on the New York stock
exchange and the American stock exchange
Results from Ferris et al (1987) study
Prediction is that stocks will have less volume after
price losses and more volume after price increases
- They reported;
- Negative abnormal volume (less trading than normal)
- Positive abnormal volume (more trading than normal)
Empirical evidence by Schlarbaum et al (1978)
investigated the length of
time a stock is held and the return received from the
stock
• Predictions are that;
• stocks sold quickly have high returns while stocks
held longer have lower returns
• stocks held for a short period are winning stocks
while those held for a long period are losing stocks as
proposed by the disposition effect
Results from Schlarbaum et al (1978) study
Annualised return for stock purchased and sold
within 1 month is 45%
• The returns for stocks held 1 to 6 months, 6 to 12
months, & more than one year were 7.8%, 5.1%, &
4.5%, respectively
• The study found that investors are quick to sell
winners
Disposition effect in relation to news
Firm-specific news
• Good news about a firm induces investors to sell (selling
winners)
• Bad news about a firm does not induce investors to sell
(holding losers)
Macroeconomic news
• News about the economy does not induce individual
investor trading
How to avoid disposition effect in relation Lim (2006)
-Cluster the selling of losers into one day
• Take all the pain of regret at once over a short time
period
-Separate selling of winners over many days
• Prolong the feeling of pride
