We investigate whether prospect theory preferences can predict a disposition effect. We consider two implementations of prospect theory: in one case, preferences are defined over annual gains and losses; in the other, they are defined over realized gains and losses. Surprisingly, the annual gain/loss model often fails to predict a disposition effect. The realized gain/loss model, however, predicts a disposition effect more reliably. Utility from realized gains and losses may therefore be a useful way of thinking about certain aspects of individual investor trading. ONE OF THE MOST ROBUST FACTS ABOUT THE TRADING of individual investors is the “disposition effect”: when an individual investor sells a stock in his portfolio, he has a greater propensity to sell a stock that has gone up in value since purchase than one that has gone down. The effect has been documented in all the available large databases of individual investor trading activity and has been linked to important pricing phenomena such as post-earnings announcement drift and stock-level momentum. Disposition effects have also been uncovered in other settings—in the real estate market, for example, and in the exercise of executive stock options. 1 While the disposition effect is a fundamental feature of trading, its underlying cause remains unclear. Why do individual investors have a greater propensity to

While several studies have documented behavioral biases in the behavior of individual investors, very little is known about the existence of such biases in corporations. We utilize the unique nature of Real Estate Investment Trusts (REITs) to test for the presence of one of the most widely discussed biases, the disposition effect. Using property level REIT data, we find strong statistical evidence that REITs tend to sell winners and hold losers, where winners and losers are defined using changes in properties ’ prices since they were acquired. In addition, we find evidence that this behavior is consistent with the disposition effect. REITs are significantly less likely to sell properties that have a loss relative to a reference point based on inflation or historical average returns, controlling for the properties ’ recent returns. Our results also indicate that companies that show greater tendencies toward disposition effect behavior tend to sell winner properties at lower prices, all else equal. We find no support for three alternative explanations, optimal tax timing, mean reverting property-level returns, and asymmetric information. Finally, we find that the effect is stronger for smaller properties and that firms showing the strongest evidence of the disposition

We study the possibility that, aside from standard sources of utility, investors also derive utility from realizing gains and losses on assets that they own. We propose a tractable model of this “realization utility, ” derive its predictions, and show that it can shed light on a number of puzzling facts. These include the poor trading performance of individual investors, the disposition effect, the greater turnover in rising markets, the effect of historical highs on the propensity to sell, the negative premium to volatility in the cross-section, and the heavy trading of highly valued assets. Underlying some of these applications is one of our model’s more novel predictions: that, even if the form of realization utility is linear or concave, investors can be risk-seeking.

This report gives a brief introduction to Behavioral Finance. First, we present some thought-provoking examples based on empirical human behavior in risky and uncertain decision-making. Then, we present some history on rationality that is the support of formal theories on finance and economics. Finally, we introduce two applications of behavioral modelling in finance. 1

Though known to financial academics for many years, momentum is for most investors the "undiscovered style, ” a valuable tool in building diversified portfolios with aboveaverage returns. Definition. Momentum is the tendency of investments to exhibit persistence in their relative performance. Investments that have performed relatively well, continue to perform relatively well; those that have performed relatively poorly, continue to perform relatively poorly. Momentum is about much more than buying a handful of hot stocks – it is a disciplined, systematic investing style that applies across asset classes. Intuition. Momentum is a phenomenon driven by investor behavior: slow reaction to new information; asymmetric responses to winning and losing investments; and the "bandwagon ” effect. Numerous academic and practitioner studies have confirmed momentum’s existence. Implications. Virtually all investors can expect higher risk-adjusted returns by adding momentum to their portfolios. Growth investors will see that momentum delivers much better performance. Value investors will find momentum to be an effective complement. Value-growth investors will want to consider momentum as an alternative to their growth allocation. This paper introduces a family of investable momentum indices, and in so doing, opens this powerful strategy to a broad range of investors.

This paper studies the relation between individuals ’ mutual fund flows and fund characteristics, establishing three key results. First, consistent with tax motivations, individual investors are reluctant to sell mutual funds that have appreciated in value and are willing to sell losing funds. Second, individuals pay attention to investment costs as redemption decisions are sensitive to both expense ratios and loads. Third, individuals ’ fund-level inflows and outflows are sensitive to performance, but in different ways. Inflows are related only to “relative ” performance, suggesting that new money chases the best performers in an objective. Outflows are related only to “absolute ” fund performance, the relevant benchmark for taxes. JEL classification: G11; C41; D14; H20 Keywords: Mutual fund flows; Individual investor portfolio choice; Tax-motivated trading �We thank an anonymous discount broker for providing data on individual investors ’ trades and Terry Odean for his help in obtaining and understanding the data set. Special thanks go to Joshua Pollet, Clemens Sialm, and Jay Wang for

We study the possibility that, aside from standard sources of utility, investors also derive utility from realizing gains and losses on assets that they own. We propose a tractable model of this “realization utility, ” derive its predictions, and show that it can shed light on a number of puzzling facts. These include the poor trading performance of individual investors, the disposition effect, the greater turnover in rising markets, the effect of historical highs on the propensity to sell, the negative premium to volatility in the cross-section, and the heavy trading of highly valued assets. Underlying some of these applications is one of our model’s more novel predictions: that, even if the form of realization utility is linear or concave, investors can be risk-seeking.

Behavioral Finance aims to explain empirical anomalies by introducing investor psychology as a determinant of asset pricing. Two kinds of anomalies, namely underreaction and overreaction, have been established by an impressive record of empirical work. While underreaction defines a slow adjustment of prices to corporate events or announcements, overreaction deals with extreme stock price reactions to previous information or past performance. Theoretical models have shown that both phenomena find potential explanations in cognitive biases, that is, investor irrationality. This study investigates current and past earnings surprises and subsequent market reaction for listed US companies over the period 1983-1999. The results suggest that investors simultaneously exhibit short-term underreaction to earnings announcements and long-term overreaction to past highly unexpected earnings. A potential explanation for the reported overreaction phenomenon is the representativeness bias. As I show, the overreaction and the later reversal is stronger for events, which exhibit a long series of similar past earnings surprises.

Mutual funds are pooled investment vehicles with diverse tax clienteles – taxable accounts and tax-qualified retirement accounts. Our paper investigates whether the characteristics, investment strategies, and performance of mutual funds held by diverse tax clienteles differ. Examining mutual funds ’ income distributions and holdings, we find that funds held primarily by taxable investors tend to be more tax-efficient than funds held primarily in tax-deferred retirement accounts. Despite these differences, we find no evidence that any investment constraints that may arise from the funds that pursue tax efficient management strategies result in performance differences between funds held by different tax clienteles. The preferences of portfolio managers ’ clientele should be an important part of the managers ’ investment strategies. For example, portfolio managers with high net worth or trust clients commonly consider tax effects in making investment decisions. On the other hand, managers of defined benefit pension plans have no need to consider tax effects because the portfolio is not taxed on capital gains or dividends. The decisions of both of these groups of portfolio managers are straightforward as they can focus on the

Using a unique data set of mutual fund transactions, this paper examines two widely acknowledged behavioural biases: overconfidence in trading and disposition behaviour. We test for the first bias by comparing the ex post profitability of the purchased and sold securities by mutual funds. Our empirical results show that the returns on the purchased securities are not worse than the returns on the sold securities, implying that the trades of mutual fund managers do not erode performance. The disposition bias, i.e. the reluctance of investors to sell losing stocks, is tested by the widely accepted methodology of Odean (1998). In contrast to Odean’s findings for individual investors, using the average purchase price to assess gains and losses, we reject the disposition hypothesis for our entire mutual fund sample and instead document a propensity of mutual fund managers to cut losses early. Nonetheless, some regional differences are observed. After splitting our sample into geographical subsamples, we observe disposition behaviour for the sample of UK (oriented) funds. However, the impact of this disposition behaviour seems to be limited, since we also find that the purchases by UK funds perform significantly better than the sold securities in the post‐trade period. The results from the disposition analysis are sensitive to the choice of the reference point. While no disposition effect is observed when average, first, last, or highest purchase prices serve as reference point, we document disposition behaviour for our entire sample when historical peak prices are used as reference point. This underlines the importance of the reference point in tests of disposition behaviour. 1