Emotions as Necessary Causes of Economic Behavior: - PowerPoint Presentation

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Emotions as Necessary Causes of Economic Behavior:Evidence from the disposition effect

Behavioral Finance Working Group

Cass Business School July 1-2 2010Slide2

Emotions and decision makingDecision making research

Well established literatures on:

Choices under risk

Cognitive biases

Heuristic processes

Emotions have received relatively less attention

Although a number of authors have made a case for their importance (e.g. Elster, 1998; Loewenstein, 2000)

Increasing recognition of the role of emotions in decision making

See Weber and Johnson (2009) for an overview

“

the emotions revolution has put affective processes on a footing equal to cognitive ones” (p. 53)Slide3

Emotions and decision makingAccepted explanations of many behavioral anomalies do not include a role for emotions

BUT the lack of importance of emotions in many situations has not been established

Could emotions be a

necessary cause

for some behaviors that currently have other explanations, rather than merely playing a supporting role?Slide4

Emotions and decision makingInvestigate experimentally how emotions may be necessary causes of economic behavior

Psychology literature indicates that responsibility (i.e. choice) for a decision leads to different emotions experienced

Different emotions have different valence and different associated action tendencies

We manipulate responsibility and emotions to investigate importance in economic decisions using a robust behavioral anomaly, the disposition effect

Examine minimum conditions required to produce the disposition effectSlide5

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

Not rational in the absence of a strong argument in support of mean reversion of share prices

Widely accepted explanation

Mental accounting (narrow framing)

Investors focus on individual stocks rather than on portfolio

Prospect theory (PT)

Risk averse in gain domain, risk seeking in loss domainSlide6

Disposition EffectEmpirical evidence (a few examples)Odean (1998)

Seminal paper examining discount brokerage house accounts and found that investors show a strong propensity for realizing winners rather than losers in their portfolios

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 Slide7

Disposition EffectExperimental evidenceWeber and Camerer (1998)

Investors buy/sell 6 risky assets over 14 trading periods

2 x positive, 2 x neutral and 2 x negative trends

Evidence of disposition effect

60% of shares sold were winners, 40% were losers

Average profit of shares sold > average profit shares held

Chui (2001)

Modified version of

Weber and Camerer (1998) experiment

Evidence of disposition effect and impact of psychological traits (locus of control)

Oehler, Heilmann, Läger and Oberländer

(2005)

Market based experiment over 16 trading periods, where asset market price determined endogenously by trading behavior

Evidence of disposition effectSlide8

Disposition EffectProspect theory and the disposition effect

Many studies cite prospect theory as

main, if not only, driver of the disposition effect

e.g. Garvey and Murphy (2004); Jordan and Diltz (2004); Lehenkari and Perttunen (2004); Dhar and Zhu (2006)

Causal role of prospect theory questioned by recent theoretical work by Barberis and Xiong (2009) and by recent empirical work by Kaustia (2008)Slide9

Role of emotionsEmotional arithmeticHypothesize that balance between the anticipated positive and negative emotions that result from the decision to sell or hold shares is a necessary driver for the disposition effect

Based on a balance of affect and is in line with adjustments to expected utility theory put forward by Mellers et al. (1999) and Zeelenberg et al. (2000), building on earlier work by

Loomes and Sugden (1982, 1986) and Bell (1982, 1985)

Also incorporates the role of emotions experienced as a result of the previous decision and the action tendencies associated with those emotions

Zeelenberg et al. (1998, 2000)

Regret is more associated with a feeling that one would like to correct the mistake or to have a second chance

Disappointment is more associated with wanting to get away from the experience or situation involvedSlide10

Role of emotions

Emotion

Definition

Disappointment

Emotional response to a

bad

outcome experienced as a result of the

state of the world

Elation

Emotional response to a

good

outcome experienced as a result of the

state of the world

Regret

Emotional response to a

bad

outcome experienced as a result of a

decision

Rejoicing

Emotional response to a

good

outcome experienced as a result of a

decision

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Role of emotionsAn investor holds a stock that has gone up or down in value (winner or loser) in the previous period and is experiencing emotions as a result of the prior outcome

Investor’s next decision will be determined by the balance of emotions and their associated action tendencies

Mellers et al. (1999)

“each gamble is evaluated by balancing the anticipated pleasure against anticipated pain” (p334)

Anticipation occurs at two levels:

Experienced emotions that would be crystallized at the point of sale

Probabilistic emotions relating to the future performance of the stock if it is heldSlide12

Role of emotionsThe question facing the decision maker is “do I want these emotions to continue or do I want to try and change them?”

Decision to hold

Leaves open the possibility of a change in the stock’s value in the future, which may lead to a change in the magnitude and/ or valence of the emotions relating to the stock

Decision to sell

Fixes the final experienced value at the sale price, focusing the investor on their current feelings

Will be influenced by whether the stock is a winner or a loser and whether the investor was responsible for the ownership of the stock or not

We predict that the tendency to

hold

losing shares will be

higher

in situations where ownership is a result of choice than when choice is absent

We predict that the tendency to

sell

winning shares will be

higher

in situations where ownership is a result of choice than when choice is absentSlide13

Experimental scenarioTwo initial experiments to test ideas

Experiment1

Participants experience a loss or gain without having responsibility for the outcome

This removes regret and rejoicing from the emotional equation, as they are emotions related to responsibility

We predict that a disposition effect will not be observed

Experiment 2

We included responsibility (and therefore regret and rejoicing) by letting participants choose whether to hold an investment

We predict that the presence of additional emotions arising from responsibility will lead to a disposition effect being observedSlide14

Experimental scenarioExperimental scenario

In each experiment we use one share, in order to control for mental accounting and portfolio based effects

Participants were given some background material on previous movements in the share price for Company A (Period 0)

They then observed two periods of share price movement (Periods 1 & 2)

Participants were endowed with shares or cash and were allowed to trade at different points during the two periods depending on the condition they were allocated toSlide15

Experimental scenario

Winner/Loser conditions

Two different patterns of share movement (Winner/Loser)

Loser pattern was the same as the Winner in Period 0 (the historical data)

Movements in Periods 1 and 2 for the Loser graph were produced by reflecting Winner graph in the horizontal axis

Winner graphSlide16

Experimental designs and resultsExperiment 1 – no responsibility

Design

N=131 participants

Held 10 shares in Company A

They did not choose to buy these, but inherited them from a relative

They had to hold the shares for Period 1 and could then trade, if they wished, at the start of Period 2

Monetary incentive mechanism

Cash prize draw where value depended on how much cash and shares were worth at the end of the experimentSlide17

Experimental designs and resultsExperiment 1 – no responsibility

Results

The dependent variable was the proportion of winning versus losing shares sold from P1 to P2 (analogous to Odean, 1998)

Those with winning shares sold 31% of their holding on average, those with losing shares sold 24% of their holding on average

No significant difference between winners and losers (even with risk preference taken into account)

No disposition effect!Slide18

Experimental designs and resultsExperiment 2 – responsibility

Predict that choice, and the associated responsibility, will cause the disposition effect to manifest, driven by the balance of anticipated regret and rejoicing

BUT how should we let people make the choice?

The literature on active & passive choice suggested active choice would have a stronger effect

E.g. Kahneman & Tversky (1982); Landman (1987); Cioffi & Garner (1996)

Tested both to see if a difference was observedSlide19

Experimental designs and resultsExperiment 2 – responsibility

Design

N=234 participants

Passive choice condition held 10 shares in Company A

Active choice condition held £500 cash (an equivalent value)

Other than the ability to trade at the start of Period 1, all materials, procedures and payouts were as in Experiment 1

The only difference is that respondents had responsibility for choosing to hold the share in P1Slide20

Experimental designs and resultsExperiment 2 – responsibility

Results

The dependent variable was percentage movement in share holdings

Evidence of a disposition effect!

No difference between active and passive choice

Results robust to risk preference and Period 1 holdingsSlide21

Experimental designs and resultsMeasuring emotions

Initial experiments did not measure emotions directly

Measurement would need to be made after experiencing the outcome of Period 1, but before making a decision on what to do in the next period

This could potentially affect behavior so the initial experiments looked at behavior only

Repeat prior experiment, but with the emotion measurement includedSlide22

Experimental designs and resultsExperiment 3 – measuring emotions

Design

The experiment used a 2 (WINNER/LOSER) x 2 (Choice/ No Choice) design

Evidence from manipulation check supports the effectiveness of choice in manipulating responsibility (p<0.001)

Measured regret, disappointment, rejoicing and elationSlide23

Experimental designs and resultsExperiment 3 – measuring emotions

Results

Negative emotions

Levels of regret are significantly higher in the choice condition (p<0.01)

Disappointment levels are not significantly different across conditions (p>0.05)

Positive emotions

No

significant differences in rejoicing or elation between the choice and no choice conditions

Possible elation alone could be causing behavior in winners

Investigation based on the behavioral studies confirm this; winner behavior is not affected by choiceSlide24

Experimental designs and resultsExperiment 4 – positive emotions

Design

Further experiment to establish the role of elation

Participants held an asset which they knew had experienced a good outcome, but the participant did not own the asset when the outcome occurred

These participants were compared to those in the no choice condition, who experience elation when their shares rise in value

Two versions; one measuring behavior and one measuring emotionSlide25

Experimental designs and resultsExperiment 4 – positive emotions

Results

Participants in the no choice condition experienced significantly higher levels of elation (p<0.001) than those in the new “no experience” condition

Participants in the no choice condition also sold significantly more shares (p<0.05)

Confirms the role of elation in driving behavior in Winner conditionSlide26

Summary and conclusionsSummary

The results support hypothesis that the specific emotions are necessary causes for the disposition effect

Regret drives behavior for losers, and elation for winners

Experience of losses and gains alone does not give rise to a disposition effect

Conclusion

Emotions seen to be necessary causes of economic behavior