Data from downtown Boston in the 1990s show that loss aversion determines seller behavior in the housing market. Condominium owners subject to nominal losses 1) set higher asking prices of 25-35 percent of the difference between the property's expected selling price and their original purchase price; 2) attain higher selling prices of 3-18 percent of that difference; and 3) exhibit a much lower sale hazard than other sellers. The list price results are twice as large for owner-occupants as investors, but hold for both. These findings are consistent with prospect theory and help explain the positive price-volume correlation in real estate markets.

Loss Aversion and Seller Behavior: Evidence from the Housing Market

Over the last 20 years, the field of behavioral finance has grown from a startup operation into a mature enterprise, with well-developed bodies of of both theory and empirical evidence. On the empirical side, the benchmark null hypothesis is that one should not be able to forecast a stock's return with anything other than measures of its riskiness, such as its beta. This hypothesis embodies the familiar idea that any other form of predictability would represent a profitable trading rule and hence a free lunch to investors. Yet in a striking rejection of this null, a large catalog of variables with no apparent connection to risk has been shown to forecast stock returns, both in the time series and the cross-section. Many of these results have been replicated in a variety of samples and have stood up sufficiently well that they are generally considered to be established facts. One prominent set of patterns from the cross-section has to do with mediumterm momentum and post-earnings drift in returns. These describe the tendency for stocks that have had unusually high past returns or good earnings news to continue to deliver relatively strong returns over the subsequent six to twelve months (and vice-versa for stocks with low past returns or bad earnings news). Early work in this area includes Jegadeesh and Titman (1993) on momentum and Bernard and Thomas (1989, 1990) on post-earnings drift. Another well-established pattern is longer-run fundamental reversion-the tendency for "glamour" stocks with high ratios of market value to earnings, cashflows, or book value to deliver weak returns over the subsequent several years (and vice-versa for "value" stocks with low ratios of market value to fundamentals). Standard references for this

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Disagreement and the Stock Market

The tendency of some investors to hold on to their losing stocks, driven by prospect theory and mental accounting, creates a spread between a stock's fundamental value and its equilibrium price, as well as price underreaction to information. Spread convergence, arising from the random evolution of fundamental values and updating of reference prices, generates predictable equilibrium prices that will be interpreted as possessing momentum. Cross-sectional empirical tests are consistent with the model. A variable proxying for aggregate unrealized capital gains appears to be the key variable that generates the profitability of a momentum strategy. Past returns have no predictability for the cross-section of returns once this variable is controlled for.

https://papers.ssrn.com/sol3/Delivery.cfm?abstractid=288466

Prospect Theory, Mental Accounting, and Momentum

This paper analyzes the trading records of a major discount brokerage house to investigate the disposition effect, the tendency to sell stocks that have appreciated in price (winners) sooner than stocks that trade below the purchase price (losers). In contrast to previous research that has demonstrated the disposition effect by aggregating across investors, our main objective is to identify differences in the disposition bias across individuals and explain this in terms of underlying investor characteristics. Building on the findings in experimental economics and social psychology, we hypothesize that differences in investor literacy about financial markets and trading frequency are responsible in part for the variation in individual disposition effect. Using demographic and socioeconomic variables as proxies for investor literacy, we find empirical evidence that wealthier individuals and individuals employed in professional occupations exhibit a lower disposition effect. Consistent with experimental economics, trading frequency also tends to reduce the disposition effect. We provide guidelines for investment advisors, regulators, and investment communities to utilize our findings and help investors make better decisions.

https://www.jstor.org/stable/pdfplus/20110549.pdf

Up Close and Personal: Investor Sophistication and the Disposition Effect

Theoretical models predict that overconfident investors will trade more than rational investors. We directly test this hypothesis by correlating individual overconfidence scores with several measures of trading volume of individual investors (number of trades, turnover). Approximately 3000 online broker investors were asked to answer an internet questionnaire which was designed to measure various facets of overconfidence (miscalibration, the better than average effect, illusion of control, unrealistic optimism). The measures of trading volume were calculated by the trades of 215 individual investors who answered the questionnaire. We find that investors who think that they are above average in terms of investment skills or past performance trade more. Measures of miscalibration are, contrary to theory, unrelated to measures of trading volume. This result is striking as theoretical models that incorporate overconfident investors mainly motivate this assumption by the calibration literature and model overconfidence as underestimation of the variance of signals. The results hold even when we control for several other determinants of trading volume in a cross-sectional regression analysis. In connection with other recent findings, we conclude that the usual way of motivating and modelling overconfidence which is mainly based on the calibration literature has to be treated with caution. We argue that our findings present a psychological foundation for the differences of opinion'' explanation of high levels of trading volume. In addition, our way of empirically evaluating behavioral finance models - the correlation of economic and psychological variables and the combination of psychometric measures of judgment biases (such as overconfidence scores) and field data - seems to be a promising way to better understand which psychological phenomena drive economic behavior.

Roger Ignatius

Papers

Are Investors Reluctant to Realize Their Losses

Mean Reversion across National Stock Markets and Parametric Contrarian Investment Strategies

Price Discovery without Trading: Evidence from the Nasdaq Preopening

Insider Trading Liability and Enforcement Strategy

A Re-Examination of the Exchange Rate–Interest Differential Relationship: Evidence from Germany and Japan