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Investors driven by emotion, not facts

July 25, 2011

Graphic: stocks on a board

Due to regret, investors are most likely to repurchase a stock sold for a gain that is trading below the price at which they sold it.

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.”

The full paper is available at http://bit.ly/m6Z1W4.

About the UC Davis Graduate School of Management

Established in 1981, the UC Davis Graduate School of Management offers an interactive and collaborative learning environment distinguished by globally visible faculty renowned for their research and teaching, innovative and entrepreneurial students, a rigorous MBA curriculum, strong connections to the business community and prime locations in Northern California’s economic hubs. The UC Davis MBA program is ranked among the top 6 percent in the nation by US News & World Report. The Economist ranks the school’s faculty No. 3 in the world; and The Financial Times ranks UC Davis among the top 10 percent of accredited business schools worldwide. The Aspen Institute's Center for Business Education recognizes the school among the best in the world for integrating issues of social and environmental stewardship into curricula and research.

About UC Davis

UC Davis is a global community of individuals united to better humanity and our natural world while seeking solutions to some of our most pressing challenges. Located near the California state capital, UC Davis has more than 34,000 students, and the full-time equivalent of 4,100 faculty and other academics and 17,400 staff. The campus has an annual research budget of over $750 million, a comprehensive health system and about two dozen specialized research centers. The university offers interdisciplinary graduate study and 99 undergraduate majors in four colleges and six professional schools.

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