Individual Investors and Forces Of Emotion

Presented By:
Tajbir Kaur
24123
 Introduction

In his best-selling book Irrational Exuberance,

economist Robert Shiller argues that“the emotional
state of investors when they decide on their
investments is no doubt one of the most important
factors causing the bull market” experienced around
the world in the 1990s.
 Examples
• One study using data from 26 interna_x0002_tional stock exchanges
argues that good moods resulting from morning sunshine lead to higher
stock returns.
• A sunny day might make people more optimistic so that, in turn, they are
more likely to buy stocks.
• Other researchers report that stock markets fall when traders’ sleep
patterns are disrupted due to clock changes with daylight savings time.
• A third recent study suggests that the outcomes of soccer games are
strongly correlated with the mood of investors.
• After a loss in a World Cup elimination game, significant market declines
are reported in the losing country’s market
 Is the mood of investor a mood of the market
• At a more fundamental level, though, it is not clear that there is a simple way
to characterize the relationship between mood and risk attitude. When
someone is in a poor mood, does he take more risks or fewer? The answer
probably depends on the context and the individual’s personality.
• For example, one person who is in a very sour mood may engage in risky
behavior like driving recklessly or drinking too much alcohol.Another person
who is not having a good day may shy away from risk more than usual and
simply withdraw from others. The evidence does not provide compelling
evidence that a buoyant mood consistently leads to lower risk aversion or
that a poor mood consistently leads to increased risk aversion, particularly in
a financial context.
 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 your spouse, friends, or
colleagues. 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.
• Psychologists and economists recognize the important impact regret and
pride have on financial decision-making. Researchers believe that people are
strongly mo_x0002_tivated to avoid the feeling of regret. Importantly, the
effects of pride and regret are asymmetric. It seems that the negative
emotion, regret, is felt more strongly by people.
 The Disposition Effect
• Researchers have recognized the tendency of investors to sell
superior-performing stocks too early while holding on to losing
stocks too long.14 Perhaps you have observed this behavior in
others, or even experienced it yourself. Have you ever heard
someone express a sentiment such as, “This stock has really shot
up so I better sell now and realize the gain?” Or, can you imagine
yourself thinking, “I have lost a lot of money on this stock already,
but I can’t sell it now because it has to turn around some day?”
The tendency to sell winners and hold losers is called the
disposition effect.
 Empirical Evidence
• We begin with some recent empirical evidence documenting the existence of the
disposition effect. For example, Terrance Odean, using a database that included trading
records for 10,000 discount brokerage accounts with almost 100,000 transactions during
1987–1993, carefully documented the tendency of individual investors to sell winners and
hold on to losers.15 To distinguish between winners and losers we need a reference
point. Consistent with prospect theory, Odean used the purchase price of each security
(or average purchase price in the case of multiple transactions). One issue that had to be
confronted is that in an up market many stocks will be winners, so it is natural that more
winners than losers will be sold. Odean dealt with this by focusing on the frequency of
winner/loser sales relative to the opportunities for winner/loser sales. Specifically, he
calculated the proportion of gains realized (PGR) as:
 PROSPECT THEORY AS AN EXPLANATION FOR THE DISPOSITION
EFFECT
• Hersh Shefrin and Meir Statman were the first to try to explain why the
disposition effect is observed.16 Their explanations fall into two
categories: prospect theory (coupled with mental accounting) and regret
aversion (coupled with self-control problems). While nothing precludes
the possibility of a role for both behavioral explanations, Shefrin and
Statman emphasize prospect theory over the emotion of re_x0002_gret,
and many commentators since then have followed this cue. Based on
recent research described next, however, emotion may be the more
important factor.
 PROSPECT THEORY AS AN EXPLANATION FOR THE DISPOSITION
EFFECT

• Stocks A and B have suffered losses, while

C and D have experienced gains. How
would these gains and losses affect your
behavior as an investor? After a large gain
(D), you have moved to the
risk_x0002_averse segment of the value
function. Only major reversals of fortune
are likely to move you back to the origin.
On the other hand, after a large loss (A)
you have moved to the risk-seeking
segment of the value function and, again,
you are unlikely to move quickly back to
your reference point. The implication is
that since you are less risk averse for
losers than winners, you are more likely to
hold on to them.
 House Money
• Next, we turn to another example of path-dependent behavior. Path-dependent
behavior means that people’s decisions are influenced by what has previously
transpired. Richard Thaler and Eric Johnson provide evidence regarding how
individual behavior is affected by prior gains and losses.20 After a prior gain,
people become more open to assuming risk. This observed behavior is referred
to as the house money effect, alluding to casino gamblers who are more willing
to risk money that was recently won. After a prior loss, matters are not so clear-
cut. On the one hand, people seem to value breaking even, so a person with a
prior loss may take a risky gamble in order to try to break even. This observed
behavior is referred to as the break even effect. On the other hand, an initial
loss can cause an increase in risk aversion in what has been called the snake-
bit effect.
 Affect
• Thus far we have argued that emotions, particularly regret, can impact financial
decision-making. Emotional responses are also caused by the many stimuli we
experience continuously every day. A person’s affective assessment is the
sentiment that arises from a stimulus. For instance, imagine yourself negotiating
a contract for your firm. Then imagine you had an immediate dislike for the other
negotiator. Would you guess that the outcome is probably affected by your
sentiment? Affect refers to the quality of a stimulus and reflects a person’s
impression or assessment. Cognitively, a person’s perception includes affective
reactions and, thus, judgment and decision-making are tied to the particular
reactions the person has.