How Investors’ Beliefs Rule Their Investment Decisions

25. March 2013 by Guest author

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It makes intuitive sense that the way people feel about something should dictate the way they behave—that our preferences and convictions are faithfully reflected in the choices we actually make. Although this seems a reasonable assumption, recent research in psychology and behavioral finance suggests otherwise.

One new study from Ohio State University’s Fisher College of Business shows exactly that. Itzhak Ben-David, one of the co-authors of the study, stated that “it’s not primarily a story about preferences,” but rather “it is a story about information and speculation.” The research, which appeared in the October 2012 issue of Review of Financial Studies, purports that an investor’s belief about a stock’s future performance is really what determines his or her actions—personal preferences have nothing to do with it.

Ben-David and Hirshleifer based their research on over 77,000 stock transactions that took place between 1990 through 1996 from a large discount broker, examining when investors bought and sold and how much they earned or lost each time. Had feelings and preferences been responsible for their decisions, then these would have resold stocks after a small win or a after large loss. However, the often observed “disposition effect,” a term coined by economists to describe the tendency to sell winners too early and keep losers too long, did not play a decisive role.  This did not mean investors were not loss averse, insisted Ben-David and Hirshleifer, it just meant the preference was not the over-riding factor driving the sell decision. People have a variety of reasons for trading stocks.

Another finding was that the more a stock decreased in value, the more likely it was that the investor would sell. “If investors had an aversion to realizing losses, larger losses should reduce the probability they would sell, but we found the opposite, larger losses were associated with a higher probability of selling,” stated Ben-David.

This study also took into account some previous research on overconfidence in investing. Previous work shows that men and frequent traders are more likely to be overconfident. If Ben-David and Hirshleifer’s hypothesis was correct, it would mean that overconfident people would be more likely to buy and sell quickly, which was, in fact, borne out by the data. Ben-David summed it up by saying, “They are engaged in belief-based trading.”

Most behavioral finance researchers agree that knowing one’s own biases is not useful for eliminating them. What’s more, ‘gut feelings’ are masters of disguise; most of the time they come dressed up in what look like facts and observable trends. If beliefs about the future, which are nothing other than reference points, are important for our sell/hold decisions rather than the notional win-loss situation, investors should make sure they have the right reference points.

Angie Picardo is a staff writer for NerdWallet. Her mission is to help investors stay financially savvy and save money with NerdWallet’s low interest credit cards.

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vposted on 25. March 2013 at 9:43 am

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