Investors driven by emotion, not facts

(PhysOrg.com) -- Individuals investing in stocks let their emotions guide them more than facts, often to their financial detriment, a new UC Davis study finds.

The paper, “Once Burned, Twice Shy: How Naïve Learning, Counterfactuals, and Regret Affect the Repurchase of Stocks Previously Sold,” is co-authored by Brad M. Barber, a professor in the UC Davis Graduate School of Management; Terrance Odean, a UC Berkeley professor; and Michal Strahilevitz, a Golden Gate University professor. The study is forthcoming in the Journal of Marketing Research.

“Having sold a stock, investors are disappointed if it continues to rise and regret having sold it in the first place,” said Barber. “They anticipate that their disappointment and regret will be more intense if they repurchase such a stock rather than not repurchasing it; thus investors are most likely to repurchase a stock previously sold for a gain that is trading below the price at which they sold it.”

Barber and his colleagues analyzed trading records for 66,465 U.S. households with accounts at a large discount broker between January 1991 and November 1996 and another 596,314 U.S. investors with accounts at a large retail broker between January 1997 and June 1999.

The analysis suggested that investors often make decisions based on emotions such as regret, disappointment, pride and contentment.

The researchers looked at each day an investor made a stock purchase and whether the investor had sold those same stocks for a gain or loss during the previous 252 trading days. The team found that investors not only prefer to re-buy a stock that was profitable in the past, but they are also more likely to buy such a stock if it lost value after they sold it.

All behaviors were consistent with what the researchers term “counterfactual thinking” — looking back at what could have been — and suggest that investors are motivated by a desire to avoid regret and instead feel pride.

“If the stock market were a level playing field and trading were costless, one might argue that the ability to enhance the emotional experience of investing by timing one’s repurchases in a way that feels good is welfare increasing,” the paper concludes.

“However, the enhanced emotional experience often will come with a price tag for two distinct reasons: the playing field is not level — on average institutional investors gain through trading and individuals lose. Furthermore, due to commissions and other transaction costs, trading is costly.”