Barbara Summers & Darren Duxbury
Emotions as Necessary Causes of
Economic Behavior:
Evidence from the disposition effect
Behavioral Finance Working Group
Cass Business School July 1-2 2010
Emotions and decision making
• Decision 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)
Summers & Duxbury – Emotions as Necessary Causes of Economic Behavior
Emotions and decision making
• Accepted 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?
Summers & Duxbury – Emotions as Necessary Causes of Economic Behavior
Emotions and decision making
• Investigate 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
effect
Summers & Duxbury – Emotions as Necessary Causes of Economic Behavior
Disposition Effect
• Definition
– Tendency 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 domain
Summers & Duxbury – Emotions as Necessary Causes of Economic Behavior
Disposition Effect
• Empirical 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
Summers & Duxbury – Emotions as Necessary Causes of Economic Behavior
Disposition Effect
• Experimental evidence
– Weber 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 effect
Summers & Duxbury – Emotions as Necessary Causes of Economic Behavior
Disposition Effect
• Prospect 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)
Summers & Duxbury – Emotions as Necessary Causes of Economic Behavior
Role of emotions
• Emotional arithmetic
– Hypothesize 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 involved
Summers & Duxbury – Emotions as Necessary Causes of Economic Behavior
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
Summers & Duxbury – Emotions as Necessary Causes of Economic Behavior
Role of emotions
• An 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 held
Summers & Duxbury – Emotions as Necessary Causes of Economic Behavior
Role of emotions
• The 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
absent
Summers & Duxbury – Emotions as Necessary Causes of Economic Behavior
Experimental scenario
• Two 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 observed
Summers & Duxbury – Emotions as Necessary Causes of Economic Behavior
Experimental scenario
• Experimental 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 to
Summers & Duxbury – Emotions as Necessary Causes of Economic Behavior
Experimental scenario
– 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 graph
60
value
• Winner/Loser conditions
40
20
0
1
period
Price =50 @ P0 end
Summers & Duxbury – Emotions as Necessary Causes of Economic Behavior
Price =55 @ P1 end
2
Price =60 @ P2 end
Experimental designs and results
• Experiment 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 experiment
Summers & Duxbury – Emotions as Necessary Causes of Economic Behavior
Experimental designs and results
• Experiment 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!
Summers & Duxbury – Emotions as Necessary Causes of Economic Behavior
Experimental designs and results
• Experiment 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 observed
Summers & Duxbury – Emotions as Necessary Causes of Economic Behavior
Experimental designs and results
• Experiment 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 P1
Summers & Duxbury – Emotions as Necessary Causes of Economic Behavior
Experimental designs and results
• Experiment 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 holdings
Means
Winner/ Loser
Winner
Loser
Sig. of difference
Active
choice
-0.105
0.297
0.023
**
Passive
choice
-0.277
0.270
0.003
Sig. of
difference
0.408
0.857
***
Summers & Duxbury – Emotions as Necessary Causes of Economic Behavior
Experimental designs and results
• Measuring 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
included
Summers & Duxbury – Emotions as Necessary Causes of Economic Behavior
Experimental designs and results
• Experiment 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 elation
Summers & Duxbury – Emotions as Necessary Causes of Economic Behavior
Experimental designs and results
• Experiment 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 choice
Summers & Duxbury – Emotions as Necessary Causes of Economic Behavior
Experimental designs and results
• Experiment 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 emotion
Summers & Duxbury – Emotions as Necessary Causes of Economic Behavior
Experimental designs and results
• Experiment 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 condition
Summers & Duxbury – Emotions as Necessary Causes of Economic Behavior
Summary and conclusions
• Summary
– 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
Summers & Duxbury – Emotions as Necessary Causes of Economic Behavior