Behavioral Finance Working Group Cass Business School July 1-2 2010 Emotions as Necessary Causes of Economic Behavior: Evidence from the disposition effect Behavioral Finance Working Group Cass Business School July 1-2 2010

Emotions and decision making Decision making research Well established literatures on: Choices under risk Cognitive biases Heuristic processes Emotions have received relatively less attention Although a number of authors have made a case for their importance (e.g. Elster, 1998; Loewenstein, 2000) Increasing recognition of the role of emotions in decision making See Weber and Johnson (2009) for an overview “the emotions revolution has put affective processes on a footing equal to cognitive ones” (p. 53)

Emotions and decision making Accepted explanations of many behavioral anomalies do not include a role for emotions BUT the lack of importance of emotions in many situations has not been established Could emotions be a necessary cause for some behaviors that currently have other explanations, rather than merely playing a supporting role?

Emotions and decision making Investigate experimentally how emotions may be necessary causes of economic behavior Psychology literature indicates that responsibility (i.e. choice) for a decision leads to different emotions experienced Different emotions have different valence and different associated action tendencies We manipulate responsibility and emotions to investigate importance in economic decisions using a robust behavioral anomaly, the disposition effect Examine minimum conditions required to produce the disposition effect

Disposition Effect Definition Widely accepted explanation Tendency for investors to “sell winners too early and ride losers too long” (Shefrin and Statman, 1985) Not rational in the absence of a strong argument in support of mean reversion of share prices Widely accepted explanation Mental accounting (narrow framing) Investors focus on individual stocks rather than on portfolio Prospect theory (PT) Risk averse in gain domain, risk seeking in loss domain

Disposition Effect Empirical evidence (a few examples) Odean (1998) Seminal paper examining discount brokerage house accounts and found that investors show a strong propensity for realizing winners rather than losers in their portfolios Shapira and Venezia (2001) Verify the effect among professionally managed accounts at a major Israeli brokerage house Coval and Shumway (2005) Investigate the behavior of market-makers at the Chicago Board of Trade (CBOT) and find that, consistent with the disposition effect, morning losses lead to significant afternoon risk-taking Dhar and Zhu (2006) Report that the degree to which individuals exhibit the disposition effect is influenced by their level of financial literacy and their trading frequencies

Disposition Effect Experimental evidence Weber and Camerer (1998) Investors buy/sell 6 risky assets over 14 trading periods 2 x positive, 2 x neutral and 2 x negative trends Evidence of disposition effect 60% of shares sold were winners, 40% were losers Average profit of shares sold > average profit shares held Chui (2001) Modified version of Weber and Camerer (1998) experiment Evidence of disposition effect and impact of psychological traits (locus of control) Oehler, Heilmann, Läger and Oberländer (2005) Market based experiment over 16 trading periods, where asset market price determined endogenously by trading behavior

Disposition Effect Prospect theory and the disposition effect Many studies cite prospect theory as main, if not only, driver of the disposition effect e.g. Garvey and Murphy (2004); Jordan and Diltz (2004); Lehenkari and Perttunen (2004); Dhar and Zhu (2006) Causal role of prospect theory questioned by recent theoretical work by Barberis and Xiong (2009) and by recent empirical work by Kaustia (2008)

Role of emotions Emotional arithmetic Hypothesize that balance between the anticipated positive and negative emotions that result from the decision to sell or hold shares is a necessary driver for the disposition effect Based on a balance of affect and is in line with adjustments to expected utility theory put forward by Mellers et al. (1999) and Zeelenberg et al. (2000), building on earlier work by Loomes and Sugden (1982, 1986) and Bell (1982, 1985) Also incorporates the role of emotions experienced as a result of the previous decision and the action tendencies associated with those emotions Zeelenberg et al. (1998, 2000) Regret is more associated with a feeling that one would like to correct the mistake or to have a second chance Disappointment is more associated with wanting to get away from the experience or situation involved

Role of emotions Emotion Definition Disappointment Emotional response to a bad outcome experienced as a result of the state of the world Elation Emotional response to a good outcome experienced as a result of the state of the world Regret Emotional response to a bad outcome experienced as a result of a decision Rejoicing Emotional response to a good outcome experienced as a result of a decision

Role of emotions An investor holds a stock that has gone up or down in value (winner or loser) in the previous period and is experiencing emotions as a result of the prior outcome Investor’s next decision will be determined by the balance of emotions and their associated action tendencies Mellers et al. (1999) “each gamble is evaluated by balancing the anticipated pleasure against anticipated pain” (p334) Anticipation occurs at two levels: Experienced emotions that would be crystallized at the point of sale Probabilistic emotions relating to the future performance of the stock if it is held

Role of emotions The question facing the decision maker is “do I want these emotions to continue or do I want to try and change them?” Decision to hold Leaves open the possibility of a change in the stock’s value in the future, which may lead to a change in the magnitude and/ or valence of the emotions relating to the stock Decision to sell Fixes the final experienced value at the sale price, focusing the investor on their current feelings Will be influenced by whether the stock is a winner or a loser and whether the investor was responsible for the ownership of the stock or not We predict that the tendency to hold losing shares will be higher in situations where ownership is a result of choice than when choice is absent We predict that the tendency to sell winning shares will be higher in situations where ownership is a result of choice than when choice is absent

Experimental scenario Two initial experiments to test ideas Experiment1 Participants experience a loss or gain without having responsibility for the outcome This removes regret and rejoicing from the emotional equation, as they are emotions related to responsibility We predict that a disposition effect will not be observed Experiment 2 We included responsibility (and therefore regret and rejoicing) by letting participants choose whether to hold an investment We predict that the presence of additional emotions arising from responsibility will lead to a disposition effect being observed

Experimental scenario In each experiment we use one share, in order to control for mental accounting and portfolio based effects Participants were given some background material on previous movements in the share price for Company A (Period 0) They then observed two periods of share price movement (Periods 1 & 2) Participants were endowed with shares or cash and were allowed to trade at different points during the two periods depending on the condition they were allocated to

Experimental scenario Winner/Loser conditions Two different patterns of share movement (Winner/Loser) Loser pattern was the same as the Winner in Period 0 (the historical data) Movements in Periods 1 and 2 for the Loser graph were produced by reflecting Winner graph in the horizontal axis Winner graph

Experimental designs and results Experiment 1 – no responsibility Design N=131 participants Held 10 shares in Company A They did not choose to buy these, but inherited them from a relative They had to hold the shares for Period 1 and could then trade, if they wished, at the start of Period 2 Monetary incentive mechanism Cash prize draw where value depended on how much cash and shares were worth at the end of the experiment

Experimental designs and results Experiment 1 – no responsibility Results The dependent variable was the proportion of winning versus losing shares sold from P1 to P2 (analogous to Odean, 1998) Those with winning shares sold 31% of their holding on average, those with losing shares sold 24% of their holding on average No significant difference between winners and losers (even with risk preference taken into account) No disposition effect!

Experimental designs and results Experiment 2 – responsibility Predict that choice, and the associated responsibility, will cause the disposition effect to manifest, driven by the balance of anticipated regret and rejoicing BUT how should we let people make the choice? The literature on active & passive choice suggested active choice would have a stronger effect E.g. Kahneman & Tversky (1982); Landman (1987); Cioffi & Garner (1996) Tested both to see if a difference was observed

Experimental designs and results Experiment 2 – responsibility Design N=234 participants Passive choice condition held 10 shares in Company A Active choice condition held £500 cash (an equivalent value) Other than the ability to trade at the start of Period 1, all materials, procedures and payouts were as in Experiment 1 The only difference is that respondents had responsibility for choosing to hold the share in P1

Experimental designs and results Experiment 2 – responsibility Results The dependent variable was percentage movement in share holdings Evidence of a disposition effect! No difference between active and passive choice Results robust to risk preference and Period 1 holdings

Experimental designs and results Measuring emotions Initial experiments did not measure emotions directly Measurement would need to be made after experiencing the outcome of Period 1, but before making a decision on what to do in the next period This could potentially affect behavior so the initial experiments looked at behavior only Repeat prior experiment, but with the emotion measurement included

Experimental designs and results Experiment 3 – measuring emotions Design The experiment used a 2 (WINNER/LOSER) x 2 (Choice/ No Choice) design Evidence from manipulation check supports the effectiveness of choice in manipulating responsibility (p<0.001) Measured regret, disappointment, rejoicing and elation

Experimental designs and results Experiment 3 – measuring emotions Results Negative emotions Levels of regret are significantly higher in the choice condition (p<0.01) Disappointment levels are not significantly different across conditions (p>0.05) Positive emotions No significant differences in rejoicing or elation between the choice and no choice conditions Possible elation alone could be causing behavior in winners Investigation based on the behavioral studies confirm this; winner behavior is not affected by choice

Experimental designs and results Experiment 4 – positive emotions Design Further experiment to establish the role of elation Participants held an asset which they knew had experienced a good outcome, but the participant did not own the asset when the outcome occurred These participants were compared to those in the no choice condition, who experience elation when their shares rise in value Two versions; one measuring behavior and one measuring emotion

Experimental designs and results Experiment 4 – positive emotions Results Participants in the no choice condition experienced significantly higher levels of elation (p<0.001) than those in the new “no experience” condition Participants in the no choice condition also sold significantly more shares (p<0.05) Confirms the role of elation in driving behavior in Winner condition

Summary and conclusions The results support hypothesis that the specific emotions are necessary causes for the disposition effect Regret drives behavior for losers, and elation for winners Experience of losses and gains alone does not give rise to a disposition effect Conclusion Emotions seen to be necessary causes of economic behavior