People tend to do things that make them feel good, and avoid things that make them feel bad. Intuitive, as the revelations of psychology often are, this nugget has found new application in explaining some of the seemingly irrational behaviour of individual investors. STEPHEN SHORE reports.
Nicholas Barberis, professor of finance at the Yale School of Management, and his colleague Wei Xiong at Princeton, suggest in their new paper, ‘Realisation Utility’, that there is a burst of positive or negative feeling that follows from each investment transaction. The researchers claim that this emotion is a direct influence on people’s behaviour, and by accounting for it in mathematical models, they can help explain a number of quandaries, such as why there is greater turnover in rising markets, and why individual investors tend to underperform benchmarks. Barberis presented his research last month at the Paul Woolley Centre for Capital Market Dysfunctionality Conference at the University of Technology, Sydney.
The underlying assumption of the work is that if an investor buys a stock that goes up in price and they sell it, he or she will get a burst of ‘positive utility’ right then at the moment of sale, depending on how big the realised gain is. Similarly if they buy a stock and it goes down, there will be a burst of ‘negative utility’ right then at the moment of sale, depending on big the realised loss is. “In our view this is largely a result of what people call ‘mental accounting’, Barberis explains. “When people think about their investing, they don’t think about it in terms of the overall return on their portfolio, they think about it as a series of investing ‘episodes’, where each episode is characterised by three things: the name of the investment; the purchase price; and the sale price.”
For example, he says, one episode might be: “I bought IBM at $80 and sold it at $100, or I bought my house for $280,000 and sold it for $320,000. People think about investing in a series of episodes; some of them are good, in the sense that you sold for more than the purchase price, some of them are bad, in the sense that you sold for less than purchase price. When you sell an asset at a gain you feel good because you are creating a positive new investing episode, one that you can look back upon and talk about with pleasure.
By contrast if you sell a stock at a loss you are creating a negative investing episode, one that will be painful to look back on and talk about.” Barberis admits this phenomenon probably applies more to individuals than institutions, who he thinks are trained to think about their investing history in terms of portfolio return, not a series of episodes. The theory probably applies most readily to the trading of individual stocks by an ordinary investor. Essentially what the model finds is that if an investor buys a stock he will sell it only if its price rises a significant amount above the purchase price, and he will never voluntarily sell at a loss.
Because the investor is desperate to avoid the negative feeling associated with crystallising a loss, he will postpone selling indefinitely until he is forced to do so by a liquidity shock. That means investors are willing to buy a stock with a negative expected return, so long as its liquidity is sufficiently high. Even though Barberis supposes realisation utility is linear – that is, the pleasurable feelings increase in line with size of the gain, he says investors are actually risk seeking.
“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.
Barberis says his model accounts for this coincidence. A stocks that is overvalued, or that has a high level of uncertainty about its fundamentals, has high volatility. Realisation utility investors, who love volatility, will push its price up, but they will also trade it more heavily because volatile stocks are more likely to reach their liquidation point (the price where the investor is satisfied with the size of the gain) sooner.
But perhaps the most interesting application of the theory is in explaining the zeitgeist of the credit crunch: a drop in stock prices combined with a liquidity shock is the source of negative feelings.