The Disposition Effect in the Venture Capital Decision-Making Process: An Experimental Approach Job Market Paper Simposio de Analisis Economico 2008, Zaragoza Marta Maras Universitat Pompeu Fabra December 12, 2008

MOTIVATION (1) Problem Mr. Martinez owns a portfolio consisting of stocks A and B. Since the purchase stock A went up in price from €30 to €50, while stock B was less successful and went down in price, from €70 down to €50. At the moment Mr. Martinez needs to raise money and is thinking of selling part of his portfolio. Which stocks should he decide to sell? Winning or losing stocks? FINANCIAL MARKETS RULE “Cut your losses, ride your gains!” December 12, 2008 2

MOTIVATION (2) Empirical Evidence shows the following (Frazzini, 2004): December 12, 2008 3

MOTIVATION (3) Disposition Effect (Shefrin&Statman, 1985) Tendency of investors to retain losing investments in their portfolios longer relative to their winning investments Losses hurt more than gains benefit Wealth-destroying behaviour December 12, 2008 4

LITERATURE REVIEW Disposition Effect (Shefrin&Statman, 1985) 5 MARKETS Stocks (Odean, 1998; Ranguelova, 2001), Stock options (Heath et al., 1999), Real-estate market (Genesove&Mayer, 2001), Futures (Heisler, 1994; Locke&Mann, 1999) INVESTOR BEHAVIOUR Above-average risks after losses (Coval&Shumway, 2005) Profitability of momentum trading strategy (Grinblatt&Han, 2001) Post-earnings announcement drift (Frazzini, 2006) INVESTOR TYPE Individual vs. professional (Shapira&Venezia, 1998) Wealth, experience, trading frequency (Dhar&Zhu, 2005; Chen et al., 2004) EXPERIMENTS Share positions automatically closed (Weber&Camerer, 1998; Chui, 2001) Markets with different trading mechanisms (Oehler et al.,2002) Stability across tasks and time (Weber&Welfens, 2006) December 12, 2008 5

CONTRIBUTION Existence of the Disposition Effect in venture capital markets? Importance of venture capitalists as intermediaries in financial markets Previous experimental studies focus on stock market only Differences in predictability, trading opportunities, provision of funds, publicity of information Introduction of the following features: Learning prior to decision making  controlled expertise Variations in competitive environment (venture selection process) Decomposition of performance  learning, investment choice and management Assessing costs and benefits of competition December 12, 2008 6

DESIGN (1) Prior learning and varying levels of competitive environment introduced by means of 2x3 between-subjects experimental design LEARNING STAGE * Multiple Cue Probability Learning Task December 12, 2008

DESIGN (1)‏ Example of Multiple Cue Probability Learning Task December 12, 2008

DESIGN (1)‏ Cue Abstraction Model: where  (=-25), 1 (=8),  (=2.5),  (=3.5) and  (=1)‏ Y = venture return in the next 10 years ([-100%,100%], 10% increments) XMG = market growth ([-10%,10%], 2% increments) XMC = management capability (1-10 scale) XTE = timing of entry (pioneer, intermediate, late follower) XCR = competitive rivalry (1-10 scale) December 12, 2008

DESIGN (2)‏ Prior learning and varying levels of competitive environment introduced by means of 2x3 between-subjects experimental design LEARNING STAGE * Multiple Cue Probability Learning Task * Cue Importance Ranking INVESTMENT STAGE NO COMPETITION * Venture Selection COMPETITION * Venture Competition ASSIGNMENT * Venture Assignment December 12, 2008

DESIGN (2)‏ Example of Venture Attribute Matrix in Period t=0 December 12, 2008

DESIGN (3)‏ Prior learning and varying levels of competitive environment introduced by means of 2x3 between-subjects experimental design LEARNING STAGE * Multiple Cue Probability Task * Cue Importance Ranking INVESTMENT STAGE NO COMPETITION * Venture Selection COMPETITION Venture * Venture Competition Management ASSIGNMENT * Venture Assignment December 12, 2008

DESIGN (3) Investment Stage – Investment Process December 12, 2008 13

DESIGN (3)‏ Example of Venture Performance Matrix in Period t=1 December 12, 2008

DESIGN (4) Optimal Investment Strategy Invest full amount provided in t=0 (no cash) in 2 ventures with best attribute values according to the cue model (due to upper bound on individual venture investment)‏ Keep both in portfolio until t=5 by investing maximally in the more profitable venture December 12, 2008 15

Disposition Effect: PGR > PLR DESIGN (5) Disposition Effect (Shefrin&Statman, 1985) Presence of disposition effect is reflected in the significant difference between proportion of gains realised (PGR) and proportion of losses realised (PLR)‏ Disposition Effect: PGR > PLR December 12, 2008 16

RESULTS (1)‏ No strong evidence of Disposition Effect – with purchase price as the reference point behavioural pattern in accordance with standard economic theory (Ivkovic & Weisbenner, 2007) (table1) General consistency in realising losses and apparent heterogeneity regarding realisation of gains No effects of training on Disposition Effect – training limited to venture selection, not venture management Conflicting evidence in empirical studies (Feng & Seasholes (2005), Dhar & Zhu (2005) and Genesove & Mayer (2001) vs. Chen et al. (2004))‏ December 12, 2008

RESULTS (1)‏ Alternative measures of the Disposition Effect Price trends = Last period price as reference point (table2) Individual level effects = Disposition Coefficients (table3) December 12, 2008

RESULTS (2)‏ Prior learning proved successful in training participants to make better venture choices (visible from portfolio compositions)‏ (table4) Expertise Effect – Participants with higher levels of learning (reflected in correlation values between predictions and realisations) had higher earnings in the experiment (better performance in the investment stage)‏ December 12, 2008

RESULTS (2)‏ Expertise Effect  Correlation coefficients between judgement achievement components and performance measures (table5) December 12, 2008

RESULTS (2)‏ Behaviour in subsequent venture management points to different dimensions of expertise, specifically, learning to choose and learning to manage If overall portfolio performance (i.e., earnings) is decomposed into elements involving learning, choice and management of holdings, it is shown that after training participants who faced competition had better venture management strategies than others December 12, 2008

RESULTS (3)‏ Optimal Strategy Analysis  Tracing reasons for earnings’ decreases December 12, 2008

RESULTS (3)‏ Optimal Strategy Analysis  Holding periods of winning and losing investments No Learning – no differences in holding periods Learning – equal holding periods of losing investments No Competition and Assignment – no change in holding strategy Competition – longest holding periods per winner, sold losing investments earlier after training December 12, 2008

RESULTS (3)‏ Initial venture competition and interaction gave incentives for a more rational management of acquired ventures Competition  best environment for reaching optimality in management (invested most per winner) Free selection  enhanced portfolio choices after training, invested more per winner and less per loser, but underfunded and sold best performing ventures Assigned choices  no effect of training on investment behavior December 12, 2008

DISCUSSION Implications – costs and benefits of competition Competition as the most efficient form of resource allocation and management Costs = competition is expensive and can lead to wasted effort (not getting the first-choice ventures)  inferior portfolios Benefits = enhanced strategies in management regarding winning and losing ventures December 12, 2008

THANK YOU! marta.maras@upf.edu December 12, 2008

RESULTS (1*)‏ Disposition Effect Analysis  Significance of PGR-PLR Difference (back) December 12, 2008

RESULTS (1*)‏ Disposition Effect Analysis  Price Trends Number of Exits in Period t Depending on Venture Value Gain (G) or Loss (L) in Periods t-1 and t-2 Panel A. No Learning December 12, 2008

RESULTS (1*)‏ Disposition Effect Analysis  Price Trends Number of Exits in Period t Depending on Venture Value Gain (G) or Loss (L) in Periods t-1 and t-2 (back) Panel B. Learning December 12, 2008

RESULTS (1*)‏ Disposition Effect Analysis  Cumulative distributions of disposition coefficients (a) (back) a = (S+ - S-) / (S+ + S-)) S+ (S-) = number of sales of winners (losers) if venture gained (lost) in value in the last period Panel A. No Learning Panel B. Learning December 12, 2008

RESULTS (2*)‏ Expertise Effect  Comparison of Environmental Model, Actual and Stated Decision Policies December 12, 2008

RESULTS (2*)‏ Expertise Effect  Lens Model Components December 12, 2008

RESULTS (2*)‏ Expertise Effect  Pairwise Correlation Coefficients between Judgment Achievement Components and Participant Demographics (back) December 12, 2008

RESULTS (2*)‏ Portfolio Composition and Experimental Earnings (back) December 12, 2008