Evaluate and reconcile the evidence in the finance literature that prior outcomes influence investors’ trading decisions.

The prescription of rational economic models prior gains and losses: sunk cost principle:

1.Individuals should evaluate decisions based solely on an incremental analysis

2.Only future costs and benefits are relevant

3.Rational economic decision makers should ignore prior outcomes

Behavioural Decision Research

People often violate the sunk cost principle of economics. individuals are influenced by prior outcomes when making consumption or investment related decisions

Examples : 

Escalation of Commitment: Tendency to commit additional funds to a failing project in an attempt to recoup prior sunk costs.

Evidence:

Arkes and Blumer (1985) : Faced a failing plane radar project, 85% interviewees recommended completion with the last 10% of the project fund if they were told the prior cost, while only 17% would do it without the prior cost.      A sunk cost of $10 million made the difference.

Various Explanations of the Sunk Cost Effect :

Desire to avoid waste (e.g. Arkes and Blumer, 1985)

Personal responsibility and the need for self-justification (e.g. Staw, 1976; Schulz and Cheng, 2002)

Prospect theory (e.g. Arkes and Blumer, 1985; Whyte, 1993)

Loss Aversion: S-shaped value function steeper in the loss domain than the gain domain.

Reference Point Matters: Evaluate gains and losses relative to prior outcomes.

Reflection Effect: Marginal value placed on a given gain/loss declines the further an individual’s reference point is from the origin. 边际递减效应导致输多了也就不在乎了。

Disposition effect

Definition：“Get-evenitis”

Tendency for investors to “sell winners too early and ride losers too long” (Shefrin and Statman, 1985)

Explanation: Prospect theory: Risk averse in gain domain, risk seeking in loss domain.

Critique of the Prospect theory explanation:

Barberis & Xiong (2009); Hens & Vlcek (2011)

Based on theoretical discussion and simulation suggest that prospect theory can not explain the disposition effect alone. In essence, investors with prospect theory value functions would not have bought stocks in the first place, （从本质上讲，如果人的心理价值函数是那样的话，在原点时，他就不会考虑去买股票）

Kaustia (2010)

Prospect theory predicts that the propensity to sell a stock declines as its price moves away from the purchase price in either direction

Trading data, however, show that the propensity to sell jumps at zero return, but it is approximately constant over a wide range of losses and increasing or constant over a wide range of gains （出售股票的倾向在大部分时间内使一致的）

Summers & Duxbury (2012, OBHDP)

Merely experiencing prior gain or loss not sufficient to produce disposition effect. Specific emotions drive behaviour

Evidence of Disposition Effect: 

Odean (1998) 

Examined discount brokerage house accounts and found that investors show a strong propensity for realizing winners rather than losers in their portfolios. Investors are 1½ times more likely to sell winners over losers. (人们对于winner的感知能力更强，losser的存在感很低）

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

House Money Effect

•Definition: Consider the effect of windfall gains from gambling. （快钱） “Gambling with the house money”.

Evidence of increased risk taking following prior gains, which is the contrary behaviour to prospect theory              ( prospect theory 假定人们在获得时，是risk aversion的， 因为不想承担失去的风险，这里，由于钱是快钱，导致在获得后更想去冒险）。Subsequent loss is less painful following prior gains (失去后也没觉得那么痛)

Broad implication for financial markets?

Investors care less for a market dip that follows substantial prior gains because they are “still up, relative to a year ago” ( 在股市里赢钱后，会认为是一种获得，更愿意用这个钱去冒险， 就算接下来输了，也觉得没事，反正比起一年以前，现在还是涨着的)

Empirical Evidence

Locke and Mann (2003)

Find little evidence of higher risk taking in afternoon trades for those futures traders recording gains on their morning trades. Investors focus on individual stocks rather than on portfolio

Massa and Simonov (2005)

Find the house money effect for individual stockholders in the Swedish security market. Risk seeking in gain domain, risk averse in loss domain

Liu et al (2010)

Evidence consistent with the house money effect for market-makers in the Taiwan futures exchange

Frino et al (2008)

Evidence of the effect on the Sydney Futures Exchange

Reconciling DE and HME

Disposition Effect: Risk averse after gains (sell), risk seeking after losses (hold)

House Money Effect: Risk seeking after gains (hold), risk averse after losses (sell)

Neilson (1998) theoretically reconciles seemingly contradictory effects

Shows that prospect theory S-shape value function (two-argument utility function) can capture risk aversion over gains and risk seeking over losses, but not risk aversion over losses and risk seeking over gains

Demonstrates that addition of a third factor, the income to date from the sequence, to produce a three-argument utility function is sufficient also to capture behavior akin to the house money effect.

Implications

Must be possible for the two effects to contemporaneously coexist in a single financial market

A single investor could simultaneously exhibit behavior consistent with both effects

Duxbury et al (2012) : The house money effect moderates the disposition effect

The importance of distinguishing prior outcomes along two dimensions;

unrealized or realized?

assessed at the stock or portfolio level?