Trading on Emotions

Investors’ previous experiences with a stock affect their willingness to repurchase the stock. Using detailed trades data from two brokers, Michal Strahilevitz, Terrance Odean, and Brad M. Barber 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.

They propose 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. Since many investors view their portfolios regularly, they also desire to avoid painful reminders of prior losses.

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.

Stock trading, like many other economic behaviors, is affected by emotions. It makes emotional sense that investors repurchase stocks that have decreased in value since being sold. Investors who do so feel the pleasure of making a choice that results in a better outcome than what might have been had they not previously sold the stock, while investors who repurchase at higher prices feel regret from knowing that they could have easily done better. Similarly, avoiding what has been a source of pain in the past is one of the most basic instincts that humans possess. Investors are unlikely to wish to repeat or to be reminded of actions linked to their previous failures. Thus, it is not surprising that investors are attracted to stocks that have treated them well in the past but shy away from stocks by which they were once burned.

Once Burned, Twice Shy: How Naïve Learning, Counterfactuals, and Regret Affect the Repurchase of Stocks Previously Sold, forthcoming Journal of Marketing Research, May 2011.