“They like volatility, because a very volatile stock can go up a lot, it can be sold, and they will feel great. It could also go down a lot, but then they will just postpone selling it until they are forced out of it by a liquidity shock, which they assume will be in the distant future, so it doesn’t bother them much today.” Characterising investor behaviour in this way partly explains the disposition effect; the well-known finding that individual investors have a much greater propensity to sell a stock that’s trading at a gain, relative to purchase price, rather than a loss. “Now that might seem natural,” Barberis says.

“But it has turned out to be very hard to explain on rational grounds why an investor would be more inclined to realise gains than to cut losses. Realisation utility explains some of that, because in our model the investor will only sell stocks at a gain, never at a loss.” But Barberis emphasises that realisation utility on its own does not predict the disposition effect. “You can’t just say, oh it is pleasurable to sell a stock at a gain, that doesn’t give you a disposition effect,” he says.

“For that you need to explain why someone would want to sell a stock at a gain today, rather than wait for the possibility of selling it at an even bigger gain tomorrow.” The theory also sheds light on why individual investors tend to trade a lot in their brokerage accounts, despite the fact that they destroy value in the process. The gross return of individual investors before transaction costs is usually similar to benchmarks, but after transaction costs they underperform. Why do they trade so much, when they lose money by doing so?

Barberis says individual investors understand that they are underperforming the benchmarks, but they don’t mind, because they feel compensated by these positive bursts of utility whenever they sell a stock at a gain. The theory might explain why there is much more trading in up markets than in down markets. “In our model, the investor is always willing to sell in a rising market, to get the burst of positive utility, and he is also more willing to buy, because to buy he needs capital and he will only get that if he sells.”

If the investor is motivated by realisation utility, it follows that there would be much more activity in rising markets, Barberis says. This could also apply to the empirical finding that highly-valued and overvalued stocks tend to be heavily traded and have a higher turnover than value stocks. For example, in bubbles throughout history, such as technology stocks in the late 90s, it was not only that these stocks were overpriced, they were also heavily traded.

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