Individual Investors and the Force of Emotion

1. Individual Investors and the Force of Emotion

2. Does mood move markets? • One study using data from 26 international stock exchanges shows good moods resulting from morning sunshine lead to higher stock returns. • Other researchers report that stock markets fall when traders’ sleep patterns are disrupted due to clock changes due to daylight savings time. • A third study suggests that World Cup outcomes are strongly correlated with the mood of investors. • After a loss in an elimination game, significant market declines were reported in the losing country’s market

3. Mood and risk attitude • But it is not clear there is a simple way to characterize relationship between mood and risk attitude. • When someone is in a poor mood does he take more risks or fewer? • Answer probably depends on context and individual’s personality

4. Mood and risk attitude cont. • Some research suggests happier people are more optimistic and assign higher probabilities to positive events. • But at same time, other decision-making research indicates that even though people may be more optimistic about their likelihood of winning a gamble when they are happy, same people are much less willing to actually take the gamble. • In other words, they are more risk averse when they are happy

5. Pride and regret • Regret is obviously a negative emotion. • You might regret a bad investment decision and wish you had made a different choice • Your negative feelings are only amplified if you have to report a loss to someone • Pride is the flip side of regret. • You probably would not mind too much if it just slipped out in conversation that you made a good profit on a trade

6. Disposition effect One puzzle in finance is disposition effect: tendency to sell winners too early and hold on to losers too long. If anything, because of tax reasons, you should be quicker to take losses. This may be driven by regret: if you cash in a loser you have to face fact that you made a mistake.

7. Evidence on disposition effect • To distinguish between winners and losers a reference point is needed. • Purchase price of a security is a natural reference point • More precisely, appropriate to focus on frequency of winner/loser sales relative to opportunities for winner/loser sales. • Specifically, proportion of gains realized (PGR) is:

8. Evidence on disposition effect cont. And proportion of losses realized is: Test of disposition effect: proportion of gains realized should exceed proportion of losses realized.  This turned out to be true.

9. Disposition effect, prospect theory and mental accounting Another view: some explain disposition effect by prospect theory and mental accounting. If a security has made money from the original date of purchase it moves up along the prospect theory value function (to points C and D) While, if a security has lost money, it moves down along the same function (to A and B).

10. Prior gains and losses, and risk aversion C D A B

11. Prospect theory and mental accounting explanation cont. The farther you are away from risk-seeking domain, the less likely it is that a particular gamble will be partly influenced by risk seeking. So risk aversion is higher for gambles beginning at D vs. C, or C vs. B, or B vs. A. Demand will be higher/lower for securities that have suffered capital losses/gains.

12. Experimental evidence • Experimental evidence favors emotions over prospect theory in explaining disposition effect. • Experimental design was predicated on whether or not individuals have chosen their investments. • When no choice you will experience disappointment • When choice you will experience regret (which is stronger than disappointment) • So disposition effect should be stronger with choice – which turned out to be true.

13. House money effect • Successful investment can cause elation (great happiness). • And bad investments can cause distress. • It is argued that result is that prior gains and losses can cause changes in risk taking. • Say you are at a casino. You do really well at blackjack and you are up $200. • Do you play more or less aggressively?

14. Conflicting effects Mood maintenance: “I am feeling good. I should walk away and enjoy this feeling.” House money: “This is the house’s money. Let’s have some fun and really make some money.” Likely many people are influenced by both impulses. Though evidence is that house money dominates. Or we can think in terms of prospect theory and mental accounting again…

15. House money and value functionof prospect theory After gains you are less likely to face loss-aversion kink This is on assumption that you do not segregate gambles – moving to 0 reference pt.

16. What about after losses? • Symmetry might suggest you should become more risk averse after losses. • This is snake-bit effect: “I have lost a lot from risky investments so now I am moving towards a much less risky portfolio” • And some do seem to act this way • But some evidence (e.g., “Deal or No Deal” research) suggests greater risk taking after losses. • Consistent with prospect theory and still being distant from loss aversion kink • Suggests you want to “get even”

17. Affect and financial decision-making • Positive affect is a “warm and fuzzy feeling.” • One study looked at relationship between image of a market and behavior of investors. • Emotion induced by the stimulus of considering a given industry is highly correlated with probability a participant would choose to invest in that industry