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FIN 355 Behavioral FinanceClass 3. Individual Investor Behavior

Dmitry A Shapiro

University of Mannheim

Spring 2017

Dmitry A Shapiro (UNCC) Individual Investor Spring 2017 1 / 27

Stock Market Non-participation

A lot of people did not invest at all in stock market;Mankiw and Zeldes (JFE, 1991): in 1984 only 28% had investedinto stock market ;All theories say they should;Heaton, Lucas (2000):

Take “background risks” seriously (housing risk, labor risk, etc.)Still should invest stock since stocks are not correlated with theserisks.

Transaction cost explains some non-participation but not all of it:

There are wealthy and sophisticated people who do not participate.

Note : with plain risk-aversion you still should invest something.


Behavioral Hypothesis

Bernatzi and Thaler (QJE, 1995) show that if agents has prospectutility over annual gains/losses then they are reluctant toparticipate.If you are loss averse over annual gains and losses in stocks thenno participation;Your value of (110, 0.5,−100, 0.5) is 0.5 · 110 − 2 · (100)/2 < 0 so donot want to invest.Loss aversion is NOT enough either because most people havebackground risks and that the stock market would diversify.

Say other risks are (30000, 1/2,−10000, 1/2)Utility is 1/2(30000) + 1/2(10000)(−2) = 5000 where −2 comes fromloss aversions.With that additional lottery the risk structure becomes:(30110, 1/4, 29900, 1/4,−9890, 1/4,−10100, 1/4)Its utility is approximately 5007.

Need loss aversion and narrow framing to explain the rejection


Non-participation

Why narrow frame the stock market?As before: either non-consumption utility, e.g. regret or intuition.The background risks are not immediately accessible while stockinformation is.Test of the model is Dimmock and Kouwenberg (JEF 2010) “LossAversion and Household Portfolio Choice”.

Measures loss aversion from household survey data;Shows that more loss averse households are less likely toparticipate.


Ambiguity Aversion/Competence

Stock market distribution is ambiguous so stay away, ORStock market distribution is ambiguous and the agent does notfeel competent to evaluate it.Formalization:

Epsten and Schneider “Learning Under Ambiguity”, 2005.


Underdiversification

a) home bias

French/Poterba, AER 1991 showed that 94% into domesticportfolio;

b) home-bias “at home”: within a country people buy stocks locatednearby

US data: Ivkovich & Weisbenner (JF, 2005);US data: portfolios of local holdings do not generate abnormalperformance (Seascholes & Ju, JF 2010);Scandinavian data: Greenblatt & Kelojarhn (JR, 2001);

c) excessive allocation to own company stock in 401(k) plan;d) significant positions in a few stocks.



Loss Aversion/Narrow Framing applies to a) and d)

By framing narrowly you ignore diversification benefits

Risk-seeking, e.g. via π(p) in PT

If some stocks are positively skewed, a PT investor may want totake a large undiversified position in a few of them.Intuition: by doing that the investor gets a lottery like payoff and PTinvestors like it.A nice paper on the topic Polkovnichenko (2005);Allocation between T-bills, market and stock (positively skewed). PTinvestor puts a lot on the stock which makes his positionundiversified.Mitton and Vorkink (RFS, 2007): underdiversified investors holdmore positively skewed stocks and they underperform.



Ambiguity Aversion (applies to a), b), c)). How to vary it?Competence Hypothesis (Heath, Tversky (1991), Fox and TverskyQJE (1995))

Competence is what you feel you know relative to what could beknown.This is testable: AA will increase for a bet if you are reminded aboutbets you know more about.

This is what happens in Ellsberg paradox

Another prediction: AA can be increased if people are remindedabout other more competent people.

When for students of San Jose University it was mentioned thatparticular bets for stock movements were also observed by stockanalysts then WTP decreased.



Ambiguity Aversion/Competence (applies to a), b), c))

Foreign countries, distant stocks are less familiar so I avoid them;Test: Graham, Huang and Harvey (2005): investors whoself-report(!) to be more confident trade more often and have morediversified portfolio.

Loyalty (a,c)

Cohen (2004) “Loyalty Based Portfolio Choice”

Larger allocation of company stock in stand-alone companies notconglomerates;Increase amount of investments after spin-off and decrease aftermerge

Patriotism

In more patriotic countries there is more home-bias;People living in more patriotic states have higher home bias.



Optimism (a,b, c)

If you optimistic about your prospects you will be optimistic aboutyour country, etc.Test: Kilka, Weber (2000): US students higher return and smallerconfidence interval on US stocks versus German stocks. Germanstudents are the opposite.Strong/Xu (2003): local fund managers assign higher returns tohome country


Underdiversification. Effect of Attention

Barber and Odean (JFE, 2008): All that Glitters: The Effect ofAttention and News on the Buying Behavior of Individual andInstitutional Investors.

Attention is a scarce resource;Attention affects buying more than selling:

There are tons of potential candidates to buy;Most individual investors hold relatively few common stocks (mean4.3 and median 2.61).Individual investors sell only stocks that they already own; they do notsell short (less than 1% of positions are short).

This buy-sell asymmetry is smaller for institutional investors.


What Grabs Attention?

Three indirect ways:

news;unusual trading volume;extreme returns.


Summary

When someone buys - someone sells;Professional investors should exhibit a lower tendency to buy, onhigh-attention days and a higher tendency on low-attention days;For example, individual investors make nearly twice as manypurchases as sales of stocks experiencing unusually high tradingvolume (e.g. the highest 5%).Similarly individual investors are net buyers of stocks withextremely good or extremely bad last day returns;


Attention Allocation Theories

Home bias and under-diversification can be rationalized usingattention allocation theories (Mondria and Wu, 2011):

investors need to decide how to allocate their attention;assume small informational advantage about local stocks;optimally to process information about local assets and hold agreater portion of local stocks (as compared to market portfolio);thus initial and small asymmetry gets magnified further.


Test. Mondria and Wu (2011)

Attention can be measured using Google Trend website thatshows the number of searches across different regions anddifferent time periods.Using tickers for the stocks in S&P500 authors document thatinvestors search 43% as much information about local stocks.Stocks with abnormal asymmetric information are defined asthose for which locals allocate more attention than nonlocals.Authors claim that there is a difference in returns between highasymmetry stocks and no-asymmetry stocks. High asymmetrystocks have higher return.


Naive Diversification

Bernatzi and Thaler (AER, 2001) Even if people diversify theyallocate 1/n wealth to each n investment options regardless ofwhat they are.

Experimental test. Three groups:

Bond fund vs. stock fund;Bond fund vs. balanced fund;Stock fund vs. balanced fund;In all three cases 50-50 was the most popular but that means verydifficult allocation.

Field test:

Plans with more equity funds should see more equity allocation.Look at 170 big pension plans;If equity funds fraction is 37% then the allocation is 49%;If equity funds fraction is 65% then the allocation is 60%;If equity funds fraction is 81% then the allocation is 64%;


Naive Diversification

The 1/n heuristics is motivated by marketing diversificationheuristics.

When make multiple decisions at the same time go with differentoptionsSimonsa (90, JMR) a candy example.

Hubermang and Jiang (JF, 2005) have better data.Prediction: If more funds are offered then people will hold morefunds.NOPrediction: If more equity funds are offered then people willallocate more to the equityNOOverall: people do allocate 1/n over those funds that they choose.


Excessive Trading

Barber/Odean (JF, 2000) have a huge database from 1991 to1996 of individual trading

Average returns of individuals is below all sorts of benchmarkssuch as: portfolio they had in the beginning of the year, marketportfolio, CAPM benchmark, 3 factor model benchmark.This in net returns (!) after transaction costs. No strongunderperformance in gross returns.The more you trade the worse you do (gross is higher than S&P500the net is lower).


Excessive Trading

Why people trade a lot rationally?

Liquidity or need for cash;

If they need liquidity why would they put money in stock to beginwith

Information

Then they should do well

Rebalancing/Hedging

More trading is going on

Tax reasons

Happens on tax-deferred accounts;Applicable only when you sell stock at loss.


Excessive Trading

Behavioral view: Overconfidence

Test: Barber/Odean (QJE, 2001): overconfidence varies withsome characteristics. Men are more confident so they trade more.Barber/Odean (RFS, 2002): switch from phone trading to onlinetrading. People now have more information so they feel moreconfidence and trade more.Glaser/Weber (2007) have dataset of online traders in Germany1997-2001.

Use a questionnaire to the people from their databaseOptimistic people trade more, overconfident do not.Optimistic people do not do better. They are not rationallyoptimistic.

Another behavioral story is entertainment


Selling Decisions. Disposition Effect

Disposition effect: people are reluctant to sell at loss relative topurchase price.

Odean (JF, 1998) have a 1987-1993 data from discountbrokerage.Find that people tend to sell stocks at a gain rather than at a loss.Rational explanations:

InformationSubsequent returns of sold stock is higher than that of the losers thatindividuals hold

Liquidity (cannot explain it)Taxes:

No they should predict the opposite.However, there is a December effect when people sell losersDisposition effect is weaker in taxable accounts but still it dominates(Ivkovich/Poterba/Weisbenner AER, 2005)

Genesove/Meyer (QJE, 2002) disposition effect in housingmarkets.


Disposition Effect

Behavioral Hypothesis:

Conservatism:

Form the opinion and too slow to update the belief.Assume good news is released after you formed the opinionIgnore it, think that the price is too high and sell.

Prospect Theory/Narrow Framing

If in gains you are risk-averse and prefer to sell;If in losses you are risk-seeking and prefer to keep;Barberis/Xiong (JF, 2009) formalize the idea.


Disposition Effect

Linnainmaa (JF, 2010) used Finnish individual investor tradingdata to show that the disposition effect can be explained in largepart by investors’ use of limit orders:


Disposition Effect

Chang, Solomon (JF, 2015):Hypothesis: investors avoid realizing losses because they dislikeadmitting that past purchases were mistakes;Delegation reverses the effect since its managers who made themistake;Show the disposition effect applies only to nondelegated assets(e.g. individual stocks);Delegated assets, like mutual funds exhibit robustreverse-disposition effect;


Trading and Learning

Individual investors:

underperform standard benchmarks. e.g. low cost index fund;sell winning investments while holding losing investment;are heavily influenced by limited attention and past returnperformance;tend to hold underdiversified portfolios;

In addition, individual investors learn wrong:engage in naive reinforcement behavior learning by repeating pastbehaviors that coincided with pleasure while avoiding pastbehaviors that generated pain;


Trading and Learning.

Investors are more likely to purchase a stock they previously soldfor a profit than one sold for a loss (Strahilevitz et al. 2011);Investors more likely to buy a stock in an industry if their previousinvestment in this industry have earned a high return (Huang,2010);Investors whose 401(k) experienced greater return or lowervariance increase their savings rate (De, Gondhi and Pochiraju,2010);Investors whose age cohorts have experienced high stock marketreturns throughout their lives are less risk-averse and more likelyto invest in stocks (Malendier and Nagel, 2011);


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