Tuesday, June 21, 2011

Once Burned, Twice Shy: How Naïve Learning, Counterfactuals, and Regret Affect the Repurchase of Stocks Previously Sold

Investors’ previous experiences with a stock affect their willingness to repurchase the stock. Using detailed trades data for two brokers, we document that investors are reluctant (1) to repurchase stocks previously sold for a loss and (2) to repurchase stocks that have risen in price subsequent to a prior sale. We propose that this behavior is driven by investors’ emotional reactions to trading and their attempts to distance themselves from negative emotions (e.g., disappointment and regret). Investors are disappointed when they sell a stock for a loss and regret having ever purchased the stock; these negative emotions deter investors from later repurchasing stocks sold for a loss. Having sold a stock, investors are disappointed if the stock continues to rise and regret having sold the stock in the first place; these negative emotions deter investors from repurchasing stocks that go up after being sold. Thus investors engage in reinforcement learning, by repurchasing stocks whose previous purchase resulted in positive emotions and avoiding stocks whose previous purchase resulted in negative emotions.

Source: U.C. Berkeley Haas School of Business, Terrance Odean

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