Finance for Normal People Chapter 7: Behavioral
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Finance for Normal People Chapter 7: Behavioral Finance Puzzles: The dividend puzzle, the disposition puzzle, and the puzzles of dollar-cost averaging and time-diversification Behavioral finance puzzles Four important financial puzzles: The
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01
Finance for Normal People
Chapter 7: Behavioral Finance Puzzles: The dividend puzzle, the disposition puzzle, and the puzzles of dollar-cost averaging and time-diversification<br>
Chapter 7: Behavioral Finance Puzzles: The dividend puzzle, the disposition puzzle, and the puzzles of dollar-cost averaging and time-diversification<br>
02
Behavioral finance puzzles Four important financial puzzles:
The dividend puzzle is about the preference for spending dividends while refraining from selling stocks and spending their proceeds
The disposition puzzle is about the disposition to realize gains quickly but procrastinate in the realization of losses
The puzzles of dollar-cost averaging and time-diversification are about their popularity among investors despite faults in the standard arguments that underlie them<br>
The dividend puzzle is about the preference for spending dividends while refraining from selling stocks and spending their proceeds
The disposition puzzle is about the disposition to realize gains quickly but procrastinate in the realization of losses
The puzzles of dollar-cost averaging and time-diversification are about their popularity among investors despite faults in the standard arguments that underlie them<br>
03
Behavioral finance puzzles The solution to these puzzles combine:
1. Wants for utilitarian, expressive, and emotional benefits, presented in Chapter 2
2. Cognitive and emotional shortcuts and errors in Chapters 3 and 4
3. Tools for correcting errors in Chapter 5
4. Implications of expected utility and prospect theories for life-evaluation, experienced happiness, and choices in Chapter 6<br>
1. Wants for utilitarian, expressive, and emotional benefits, presented in Chapter 2
2. Cognitive and emotional shortcuts and errors in Chapters 3 and 4
3. Tools for correcting errors in Chapter 5
4. Implications of expected utility and prospect theories for life-evaluation, experienced happiness, and choices in Chapter 6<br>
04
Behavioral finance puzzles The dividend puzzle ”Why do corporations pay dividends?
Why do investors pay attention to dividends? ...
The harder we look at the dividend picture, the more it seems like a puzzle, with pieces that just don’t fit together”
Fischer Black, Journal of Portfolio Management, 1976<br>
Why do investors pay attention to dividends? ...
The harder we look at the dividend picture, the more it seems like a puzzle, with pieces that just don’t fit together”
Fischer Black, Journal of Portfolio Management, 1976<br>
05
Behavioral finance puzzles The dividend puzzle Wants for utilitarian, expressive, and emotional benefits
Saving provides utilitarian, expressive and emotional benefits and so does spending, but the two wants conflict
Distinctions between capital and dividends help us balance our conflicting saving and spending wants and regulate them<br>
Saving provides utilitarian, expressive and emotional benefits and so does spending, but the two wants conflict
Distinctions between capital and dividends help us balance our conflicting saving and spending wants and regulate them<br>
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Behavioral finance puzzles The dividend puzzle How normal-ignorant investors frame capital and dividends<br>
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Behavioral finance puzzles The dividend puzzle How rational and normal-knowledgeable investors frame capital and dividends<br>
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Behavioral finance puzzles The dividend puzzle Framing and Mental Accounting
What is the difference between $1,000 in “homemade” dividends from the sale of shares and $1,000 from a cashed company-paid dividend check?<br>
What is the difference between $1,000 in “homemade” dividends from the sale of shares and $1,000 from a cashed company-paid dividend check?<br>
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Behavioral finance puzzles The dividend puzzle Self-control
How is self control helped by separate mental accounts for capital and income and a rule of “spend income but don’t dip into capital”?
How do company-paid cash dividends facilitate exercise of self-control?
How do stock dividends facilitate exercise of self-control?<br>
How is self control helped by separate mental accounts for capital and income and a rule of “spend income but don’t dip into capital”?
How do company-paid cash dividends facilitate exercise of self-control?
How do stock dividends facilitate exercise of self-control?<br>
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Behavioral finance puzzles The dividend puzzle Hindsight, Regret, and Pride
What is the regret potential of company-paid cash dividends and homemade dividends?<br>
What is the regret potential of company-paid cash dividends and homemade dividends?<br>
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Behavioral finance puzzles The dividend puzzle Framing in prospect and expected-utility theories
Choose between:
A. $2 today and a 50-50 chance of $50 or $54 tomorrow
B. Nothing today and a 50-50 chance of $52 or $56 tomorrow<br>
Choose between:
A. $2 today and a 50-50 chance of $50 or $54 tomorrow
B. Nothing today and a 50-50 chance of $52 or $56 tomorrow<br>
12
Behavioral finance puzzles The dividend puzzle Framing in prospect theory
Consider an investor who bought the stock for $40
A. $2 dividend plus a 50-50 chance for a capital gain of either $10 or $14
B. 50-50 chance for a capital gain of $12 or $16<br>
Consider an investor who bought the stock for $40
A. $2 dividend plus a 50-50 chance for a capital gain of either $10 or $14
B. 50-50 chance for a capital gain of $12 or $16<br>
13
Figure 7-1a: Comparing prospect theory gain-loss utility with dividends are paid and not paid – The case where the price of the share increased<br>
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Behavioral finance puzzles The dividend puzzle Framing in prospect theory
Consider an investor who bought the stock for $70
A. $2 dividend plus a 50-50 chance for a capital loss of either $16 or $20
B. 50-50 chance for a capital loss of $14 or $18<br>
Consider an investor who bought the stock for $70
A. $2 dividend plus a 50-50 chance for a capital loss of either $16 or $20
B. 50-50 chance for a capital loss of $14 or $18<br>
15
Figure 7-1b: Comparing prospect theory gain-loss utility with dividends paid and not paid – The case where the price of the share declined<br>
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Behavioral finance puzzles The Disposition Puzzle Rational investors are quick to realize losses and slow to realize gains (why?)
Yet many normal investors display a disposition to “sell winners too early and ride losers too long”
Why do investors display that disposition? This is the disposition puzzle
Do you display a disposition to “sell winners too early and ride losers too long”?<br>
Yet many normal investors display a disposition to “sell winners too early and ride losers too long”
Why do investors display that disposition? This is the disposition puzzle
Do you display a disposition to “sell winners too early and ride losers too long”?<br>
17
Behavioral finance puzzles The Disposition Puzzle Wants for avoiding regret
Realizing losses imposes the emotional costs of regret whereas realizing gains yields the emotional benefits of pride<br>
Realizing losses imposes the emotional costs of regret whereas realizing gains yields the emotional benefits of pride<br>
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Behavioral finance puzzles The Disposition Puzzle Hindsight shortcuts and errors
We bought a share for $100 because we saw, in foresight, its price increasing to $140
But now, in hindsight, we remember all the warning signs displayed in plain sight on the day we bought our share<br>
We bought a share for $100 because we saw, in foresight, its price increasing to $140
But now, in hindsight, we remember all the warning signs displayed in plain sight on the day we bought our share<br>
19
Behavioral finance puzzles The Disposition Puzzle Hindsight, regret, and responsibility
We experience disappointment when a broker who bears responsibility for choosing stocks for us makes a choice that sustains losses
But we suffer regret when we ourselves bear responsibility for that choice<br>
We experience disappointment when a broker who bears responsibility for choosing stocks for us makes a choice that sustains losses
But we suffer regret when we ourselves bear responsibility for that choice<br>
20
Behavioral finance puzzles The Disposition Puzzle Methods for overcoming the disposition effect
Transfer your assets
Harvest your losses
Stop-loss orders<br>
Transfer your assets
Harvest your losses
Stop-loss orders<br>
21
Behavioral finance puzzles The disposition puzzle Framing in expected-utility and prospect theories
You bought a share of stock yesterday for $100
It is selling at $60 today
You face a 50-50 chance that the share’s price would increase by $40 tomorrow to $100 or decline by a further $40 to $20
The capital gains tax rate is 20%
Would you realize your loss?<br>
You bought a share of stock yesterday for $100
It is selling at $60 today
You face a 50-50 chance that the share’s price would increase by $40 tomorrow to $100 or decline by a further $40 to $20
The capital gains tax rate is 20%
Would you realize your loss?<br>
22
Behavioral finance puzzles The disposition puzzle Framing in prospect theory
Choose between:
A. Sell the share today thereby realizing the $40 loss
B. Hold the share for another day, accepting a 50-50 chance of losing a total $80, or getting-even, losing $0<br>
Choose between:
A. Sell the share today thereby realizing the $40 loss
B. Hold the share for another day, accepting a 50-50 chance of losing a total $80, or getting-even, losing $0<br>
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Figure 7-2a: Gain-loss utility associated with options A and B<br>
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Behavioral finance puzzles The disposition puzzle Framing in prospect theory
You bought a share of stock yesterday for $60
It is selling at $100 today
You face a 50-50 chance that the share’s price would increase by $40 tomorrow to $140 or decline by $40 back to $60
The capital gains tax rate is 20%
Would you realize your gain?<br>
You bought a share of stock yesterday for $60
It is selling at $100 today
You face a 50-50 chance that the share’s price would increase by $40 tomorrow to $140 or decline by $40 back to $60
The capital gains tax rate is 20%
Would you realize your gain?<br>
25
Behavioral finance puzzles The disposition puzzle Framing in prospect theory
Choose between:
C. Sell the share today thereby realizing a $40 paper gain.
D. Hold the share for another day, accepting a 50-50 chance of gaining a total of $80 or gaining $0<br>
Choose between:
C. Sell the share today thereby realizing a $40 paper gain.
D. Hold the share for another day, accepting a 50-50 chance of gaining a total of $80 or gaining $0<br>
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Figure 7-2b: Gain-loss utility associated with options C and D<br>
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Behavioral finance puzzles The disposition puzzle Countering the disposition effect
Rules are a self-control device facilitating the realization of losses<br>
Rules are a self-control device facilitating the realization of losses<br>
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Behavioral finance puzzles The disposition effect Countering the disposition effect
Self-control and outside control
“Magic words” such as transfer your assets or harvest your losses
The role of December
The roles of regret, fear, sadness, and disgust<br>
Self-control and outside control
“Magic words” such as transfer your assets or harvest your losses
The role of December
The roles of regret, fear, sadness, and disgust<br>
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Behavioral finance puzzles The disposition effect The disposition effect among corporate managers
Corporate managers are disposed to “throw good money after bad” into losing projects
Some of the reluctance, but not all, is due to conflicts of interest
Project review committees and workout units can counter the disposition effect<br>
Corporate managers are disposed to “throw good money after bad” into losing projects
Some of the reluctance, but not all, is due to conflicts of interest
Project review committees and workout units can counter the disposition effect<br>
30
Behavioral finance puzzles The puzzles of dollar-cost averaging and time-diversification The dollar-cost averaging puzzle centers on the argument that utilitarian benefits make investment by dollar-cost averaging better than investment by lump-sum
The time-diversification puzzle centers on the argument that the risk of stocks declines as the investment horizon increases<br>
The time-diversification puzzle centers on the argument that the risk of stocks declines as the investment horizon increases<br>
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Behavioral finance puzzles Time-diversification centers on the belief that the risk of stocks declines as the investment horizon increases
That belief is shared by amateur and professional investors alike, often accompanied by graphs showing that the probability of stock market gains increases as their holding periods increases<br>
That belief is shared by amateur and professional investors alike, often accompanied by graphs showing that the probability of stock market gains increases as their holding periods increases<br>
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Figure 7-3: Proportion of stock market periods with gains by time horizon (1926-2015)<br>
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Behavioral finance puzzles The puzzles of dollar-cost averaging and time-diversification The solutions to the puzzles combine:
Wants for utilitarian, expressive, and emotional benefits
Application of expected utility and prospect theories
Roles of cognitive and emotional shortcuts and errors
Tools for correcting errors<br>
Wants for utilitarian, expressive, and emotional benefits
Application of expected utility and prospect theories
Roles of cognitive and emotional shortcuts and errors
Tools for correcting errors<br>
34
Behavioral finance puzzles The puzzle of dollar-cost averaging Framing and expected-utility and prospect theories in dollar-cost averaging
An investor with $2,000 in cash he has chosen to invest in stocks because stocks are likely to yield higher long-term wealth than cash, even though they also impose higher variance of wealth
This choice is consistent with expected-utility theory if the investor’s variance-aversion is not too high<br>
An investor with $2,000 in cash he has chosen to invest in stocks because stocks are likely to yield higher long-term wealth than cash, even though they also impose higher variance of wealth
This choice is consistent with expected-utility theory if the investor’s variance-aversion is not too high<br>
35
Behavioral finance puzzles The puzzle of dollar-cost averaging Framing and expected-utility and prospect theories in dollar-cost averaging
Loss-aversion, a feature of prospect theory, might deter our investor from buying stocks
Dollar-cost averaging overcomes loss-aversion in a frame that highlights gains and obscures losses<br>
Loss-aversion, a feature of prospect theory, might deter our investor from buying stocks
Dollar-cost averaging overcomes loss-aversion in a frame that highlights gains and obscures losses<br>
36
Behavioral finance puzzles The puzzle of dollar-cost averaging Average cost of shares held at the end of the two periods: $2000/100 = $20
Average price at which shares were bought during the two periods: (50 + 12.5)/2 = $31.25<br>
Average price at which shares were bought during the two periods: (50 + 12.5)/2 = $31.25<br>
37
Behavioral finance puzzles The puzzle of dollar-cost averaging Pride and regret in dollar-cost averaging
Investors anticipate the emotional benefits of pride and emotional costs of regret when they make choices
Investors mitigate their anticipated emotional costs of regret when they convert only one part of their cash into shares of stock today<br>
Investors anticipate the emotional benefits of pride and emotional costs of regret when they make choices
Investors mitigate their anticipated emotional costs of regret when they convert only one part of their cash into shares of stock today<br>
38
Behavioral finance puzzles The puzzle of dollar-cost averaging Self-control in dollar-cost averaging
The strict rules of dollar-cost averaging combat self-control lapses, compelling investors to stick to the stock-buying or stock-selling plan<br>
The strict rules of dollar-cost averaging combat self-control lapses, compelling investors to stick to the stock-buying or stock-selling plan<br>
39
Behavioral finance puzzles The puzzle of dollar-cost averaging Reverse dollar-cost averaging
An investor with stocks who converts her entire amount into cash today bears less variance-risk and loss-risk tomorrow than when she follows reverse dollar-cost averaging, converting only a portion into cash and keeping the other in stocks
Risk reduction cannot be the rationale for both dollar-cost averaging and reverse dollar-cost averaging<br>
An investor with stocks who converts her entire amount into cash today bears less variance-risk and loss-risk tomorrow than when she follows reverse dollar-cost averaging, converting only a portion into cash and keeping the other in stocks
Risk reduction cannot be the rationale for both dollar-cost averaging and reverse dollar-cost averaging<br>
40
Behavioral finance puzzles The puzzle of dollar-cost averaging Prospect theory
The return on cash is zero
$2,000 in stocks will, with equal probabilities, either increase by $600 to
$2,600 tomorrow or decrease by $280 to $1,720
The reference point of John is $2,000 in cash
He frames the choice as between A and B
A. Keep in cash: A sure gain of $0
B. Convert cash into stocks: A 50-50 chance to gain $600 or lose $280<br>
The return on cash is zero
$2,000 in stocks will, with equal probabilities, either increase by $600 to
$2,600 tomorrow or decrease by $280 to $1,720
The reference point of John is $2,000 in cash
He frames the choice as between A and B
A. Keep in cash: A sure gain of $0
B. Convert cash into stocks: A 50-50 chance to gain $600 or lose $280<br>
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Figure 7-4a: Choice to hold $2,000 in cash or convert it into stocks<br>
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Behavioral finance puzzles The puzzle of dollar-cost averaging The reference point of Jane is $2,000 in stocks
She frames the choice as between C and D
C. Convert stocks into cash: A 50-50 chance for an (opportunity) gain of $280 if the price of shares declines or an (opportunity) loss of $600 if the price of shares increases.
D. Keep in stocks: A sure (opportunity) gain of $0<br>
She frames the choice as between C and D
C. Convert stocks into cash: A 50-50 chance for an (opportunity) gain of $280 if the price of shares declines or an (opportunity) loss of $600 if the price of shares increases.
D. Keep in stocks: A sure (opportunity) gain of $0<br>
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Figure 7-4b: Choice to hold $2,000 in stocks or convert it into cash<br>
44
Behavioral finance puzzles The puzzle of time-diversification Framing and expected-utility and prospect theories in time-diversification
The time-diversification puzzle is related to the equity premium puzzle
$1,000 in Treasury bills at the end of 1925 compounded to a mere $12,720 by the end of 1995,
whereas $1,000 in stocks compounded to $842,000
Why are long-term investors reluctant to invest large proportions of their portfolios in stocks when the long-term expected returns from them are so much higher than those of Treasury bills?<br>
The time-diversification puzzle is related to the equity premium puzzle
$1,000 in Treasury bills at the end of 1925 compounded to a mere $12,720 by the end of 1995,
whereas $1,000 in stocks compounded to $842,000
Why are long-term investors reluctant to invest large proportions of their portfolios in stocks when the long-term expected returns from them are so much higher than those of Treasury bills?<br>
45
Behavioral finance puzzles The puzzle of time-diversification Framing and expected-utility and prospect theories in time-diversification
Jeremy Siegel and Richard Thaler offered several possible solutions to the equity premium puzzle but favored the “myopic loss-aversion,” rooted in prospect theory’s loss-aversion
The frequency of losses varies by the length of periods over which returns are observed
Losses are more frequent over short periods than over long periods
Investors who observe returns over short periods might exhibit myopic loss-aversion - misled into the belief that losses are more likely over long periods than they truly are<br>
Jeremy Siegel and Richard Thaler offered several possible solutions to the equity premium puzzle but favored the “myopic loss-aversion,” rooted in prospect theory’s loss-aversion
The frequency of losses varies by the length of periods over which returns are observed
Losses are more frequent over short periods than over long periods
Investors who observe returns over short periods might exhibit myopic loss-aversion - misled into the belief that losses are more likely over long periods than they truly are<br>
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Figure 7-5a: Distribution of returns of stocks and bonds during 1-Year investment horizons (Bond returns in black and stock returns in white)<br>
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Figure 7-5b: Distribution of returns of stocks and bonds during 30-Year investment horizons (Bond returns in black and stock returns in white)<br>
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Behavioral finance puzzles Framing and expected-utility and prospect theories in time-diversification
The median allocation to stocks among those who saw the 1-year chart was 40%. The median allocation to stocks among those who saw the 30-year chart was 90%
More recent evidence indicates, however, that myopic loss-aversion has little effect on investment choices
People invest as much in stocks when they see one-year or long-horizon historical return distributions, but they invest less in stocks when they see no historical return distributions
This suggests that lack of knowledge of high historical stock returns rather than myopic loss-aversion makes investors excessively pessimistic about future stock returns<br>
The median allocation to stocks among those who saw the 1-year chart was 40%. The median allocation to stocks among those who saw the 30-year chart was 90%
More recent evidence indicates, however, that myopic loss-aversion has little effect on investment choices
People invest as much in stocks when they see one-year or long-horizon historical return distributions, but they invest less in stocks when they see no historical return distributions
This suggests that lack of knowledge of high historical stock returns rather than myopic loss-aversion makes investors excessively pessimistic about future stock returns<br>
49
Behavioral finance puzzles The puzzle of time-diversification Framing errors in time-diversification
Paul Samuelson argued that the advocacy of time-diversification is built on framing errors that mislead investors into an illusory happy ending, as if the probability of losses over the long-run is zero
Consider an investor who invests $1,000 in a portfolio with a 50–50 chance to gain 20% or lose 10% each year
The investor has a 50% probability of losing money if her horizon is one year, but she has only a 25% probability of losing money if it is two years<br>
Paul Samuelson argued that the advocacy of time-diversification is built on framing errors that mislead investors into an illusory happy ending, as if the probability of losses over the long-run is zero
Consider an investor who invests $1,000 in a portfolio with a 50–50 chance to gain 20% or lose 10% each year
The investor has a 50% probability of losing money if her horizon is one year, but she has only a 25% probability of losing money if it is two years<br>
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Figure 7-6: Probabilities of losing money and amounts of money that can be lost<br>
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Behavioral finance puzzles The puzzle of time-diversification Framing errors in time-diversification
Many proponents of time-diversification assume, in error, that the probability of losses with stocks held over the long run is zero
Yet there is reason to expect a negative return even on the broadest possible stock index in the very long run
The error of framing small probabilities as zero probabilities might be described as the illusory-happy-ending error<br>
Many proponents of time-diversification assume, in error, that the probability of losses with stocks held over the long run is zero
Yet there is reason to expect a negative return even on the broadest possible stock index in the very long run
The error of framing small probabilities as zero probabilities might be described as the illusory-happy-ending error<br>
52
Behavioral finance puzzles The puzzle of time-diversification Regret and Self-Control in time-diversification
Time-diversification, like dollar-cost averaging, is useful in bolstering self-control and mitigating fear and regret over losses
Time-diversification comes with stay-the-course rules,
keeping alive hope of high future gains and countering the urge to sell all stocks, perhaps at the bottom of the market,
when extrapolating three bad stock market years into a world-is-coming-to-the-end conclusion<br>
Time-diversification, like dollar-cost averaging, is useful in bolstering self-control and mitigating fear and regret over losses
Time-diversification comes with stay-the-course rules,
keeping alive hope of high future gains and countering the urge to sell all stocks, perhaps at the bottom of the market,
when extrapolating three bad stock market years into a world-is-coming-to-the-end conclusion<br>
53
Behavioral finance puzzles The puzzle of time-diversification Regret and Self-Control in time-diversification
Time-diversification is usually presented in a frame where investment time horizons are fixed, set when investments are made
But investors often describe time horizons in a flexible form - simply “the long-run” - rather than in a fixed form – “30 years”
An investor with options on time can postpone the realization of paper losses, thereby avoiding closing a mental account at a loss and suffering the accompanying pain of regret<br>
Time-diversification is usually presented in a frame where investment time horizons are fixed, set when investments are made
But investors often describe time horizons in a flexible form - simply “the long-run” - rather than in a fixed form – “30 years”
An investor with options on time can postpone the realization of paper losses, thereby avoiding closing a mental account at a loss and suffering the accompanying pain of regret<br>