Selling winners, buying losers: Mental decision rules of individual investors on their holdings

AuthorManuel J. Rocha Armada,Gilberto Loureiro,Cristiana Cerqueira Leal
Published date01 June 2018
Date01 June 2018
DOIhttp://doi.org/10.1111/eufm.12145
DOI: 10.1111/eufm.12145
ORIGINAL ARTICLE
Selling winners, buying losers: Mental decision
rules of individual investors on their holdings
Cristiana Cerqueira Leal
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Gilberto Loureiro
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Manuel J. Rocha Armada
NIPE & School of Economics and
Management, University of Minho,
Campus de Gualtar, 4710-057 Braga,
Portugal
Emails: rarmada@eeg.uminho.pt;
gilberto@eeg.uminho.pt;
ccerqueira@eeg.uminho.pt
Funding information
This work was carried out within the
funding with COMPETE reference n°
POCI-01-0145-FEDER-006683, with the
FCT/MECs (Fundação para a Ciência e a
Tecnologia, I.P.) financial support through
national funding, and by the ERDF through
the Operational Program on
Competitiveness and Internationalization
COMPETE 2020under the PT2020
Partnership Agreement.
Abstract
We extend the study of the disposition effect the
preference for selling (holding) current winning (losing)
stocks by adding a new element to this decision process:
the investorspreference to purchase additional units of the
current losing stocks. Using a unique database, we find that
individual investors prefer to sell their winning stocks and,
simultaneously, hold and increase their exposure to the
losing ones. The additional purchase is pervasive across
investors, but stronger for less sophisticated investors. Our
evidence suggests that reference prices, prior stock returns,
stock visibility, and investor performance and sophistica-
tion are determinants of investorstrading behavior.
KEYWORDS
additional purchase, disposition effect, individual investors, mental
accounting, portfolio choice, trading decision
JEL CLASSIFICATION
G02, G11, G14
We are grateful to anonymous referees, John Doukas as well as participants at the European Financial Management
Association Annual Meeting in Basel 2016, the International Meeting of the Academy of Behavioral Finance & Economics
in Venice 2016, and the Portuguese Finance Network Conference in Covilhã 2016 for helpful comments and suggestions.
This work was carried out within the funding with COMPETE reference n° POCI-01-0145-FEDER-006683, with the FCT/
MECs (Fundação para a Ciência e a Tecnologia, I.P.) financial support through national funding, and by the ERDF
through the Operational Program on Competitiveness and Internationalization COMPETE 2020under the PT2020
Partnership Agreement.
362
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© 2017 John Wiley & Sons, Ltd. wileyonlinelibrary.com/journal/eufm Eur Financ Manag. 2018;24:362386.
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INTRODUCTION
One of the most well-documented patterns in the literature on individual investor trading behavior is
the disposition effect: investorspreference for selling stocks that are at a gain and holding stocks in
their portfolios that are at a loss (Shefrin & Statman, 1985). We extend the study of the disposition
effect by introducing an additional component to this trading pattern, namely, the preference to
purchase additional stocks that investors currently hold at a loss in their portfolios. Investors can either
sell, keep, or make additional purchases of the stocks they currently hold in their portfolios. The
literature on the disposition effect essentially addresses the first two dimensions of the investors
trading behavior by exploring the reasons why investors sell or keep the stocks they own, which are
shown to be related to the prior performance of their holdings. However, the literature has neglected the
fact that the prior performance of investorscurrent holdings may also affect another aspect of their
trading behavior the decision to purchase additional units of those stocks. In this paper, we contribute
to the literature by showing that past performance of investorsholdings affects their trading behavior
in a broader way than what is described by the disposition effect. We find that not only do investors
have a preference for selling winning stocks and keeping the losing ones, they also reveal a preference
to purchase additional units of the stocks in which they are currently losing. We argue that the
additional purchase of losing stocks is an extension of investorstendency to hold on to losing
investments. According to the disposition effect, investors keep their losing stocks to avoid realizing a
loss, while hoping for a stock price recovery that will break-even. Since the price of the current losing
stocks is low, and because investors keep the expectation of a future stock price recovery, the purchase
of additional units of those stocks is seen as a good investment decision. First, because investors
perceive that they will be in a better situation than if they had purchased all units at the initial price.
Second, because buying additional units of their current losing stocks reduces the average purchase
price per unit and makes it easier to achieve the break-even on those stocks. Investors think that they are
able to recover from the loss and the additional purchase facilitates the break-even process. These ideas
were verbalized by a few investors from our sample that we interviewed to uncover the behavioral
grounds of the additional purchase of current losing stocks.
1
We study the stock portfolios of 4,428 individual investors over a 4-year period from August 2003
to July 2007. The data were provided by a well-known Portuguese brokerage house and the individual
investors under analysis are their discount brokerage clients (with online accounts). These investors,
mainly Portuguese, have easy access to international markets through NYSE Euronext. Nevertheless,
their portfolios are biased towards the domestic stock market, in line with the literature that reports
home bias (Coval & Moskowitz, 1999; Graham, Harvey, & Huang, 2009; Lauterbach & Reisman,
2004). Motivated by the studies that suggest that individual investors trade too much (Odean, 1998b),
but are under-diversified (Goetzmann & Kumar, 2008), we question whether and why investors
express preferences for trading on their current holdings (either by selling or purchasing additional
1
We conducted exploratory interviews with some investors from our sample in the last year of our sample period. From the
interviews, the behavioral nature of the preference to purchase additional units of the current losing stocks is clear.
Investors refer to the additional purchase of losing stocks as a average cost strategy.They also make some strong
statements, such as I cannot sell at a loss;There is a strategy: if I buy a sock and thereafter it goes down significantly, to
mitigate the loss, I buy more units at the current price;Sometimes, when Im losing I make an additional purchase. [...]
It will be much easier to breakeven.Even investors that had accumulated larger losses with this trading strategy admit that
they keep doing it: It is like fooling myself, [laugh], it really is. My argument is that I want to get out of that mistake [the
initial purchase decision that leads to a loss]. I have the expectation to correct the mistake and I buy [more units of the
stock] at a lower price, to lower the average price, hoping to get rid of all.
LEAL ET AL.
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