Forget logic. Investment is driven mostly by emotion

A behavioural finance expert says investors are not as dispassionate as you’d think

Prof Terrance Odean: Managers were 17 per cent more likely to repurchase a stock if they had previously sold it for a profit rather than a loss

Fund managers, armed with an almost infinite amount of fundamental and technical information, buy and sell stocks every day. However, while they may aim to be objective and dispassionate, new research suggests fund managers’ emotions – pride and happiness, regret and disappointment – are often the key drivers of their decisions.

Investors feel good when they sell a stock for a profit, whereas selling a stock at a loss is associated with negative emotions, notes Berkeley-based behavioural finance expert Prof Terrance Odean in a new paper, Stock Repurchasing Bias of Mutual Funds.

A previous Odean study, published in 2011, had already shown ordinary investors are more likely to repurchase stocks they have previously sold for a profit than stocks they had sold for a loss, the likely reason being they are seeking to repeat the initial positive experience and avoid the negative one with “loser” stocks. Might these basic emotional instincts also sway sophisticated fund managers?

Short answer: yes. Examining data from 1980 to 2014, Odean found managers were 17 per cent more likely to repurchase a stock if they had previously sold it for a profit rather than a loss. They were even more likely to repurchase a winning stock if the price had fallen after they sold it. The so-called repurchase effect was less pronounced if the stock price had increased after the sale, the likely explanation being this increase caused “regret and a negative feeling that the stock has been sold in the first place”.


Magnitude of gains

The magnitude of gains didn’t impact fund managers’ behaviour – fund managers seem to think a win is a win, so extremely large gains were not associated with a greater likelihood of repurchase than modest gains. With losing stocks, however, the more money a fund manager had previously lost on a stock, the less likely they were to repurchase it at a later date.

This asymmetric reaction also has its roots in human psychology, specifically in loss aversion – it’s estimated that for most people, the pain of a euro lost is at least twice as great as the joy of a euro gained.

“When deciding whether to repurchase a stock, the magnitude of losses and the associated pain may thus be more vivid and influence the repurchasing probability,” says Prof Odean. “For gains it only seems to matter that the stock was sold with a positive return, and not so much at what magnitude.”

Alternative and non-emotional factors may explain the findings, of course, but Odean thinks this is unlikely. Firstly, investors are much more likely to repurchase a winning stock if the memory of it is “more salient to the manager” – that is, if it had been sold relatively recently or if it was an individual sale, as opposed to one of many stock trades made at the same time.

Secondly, repurchased stocks tended to increase in price between the time they were sold and repurchased, suggesting funds would have benefited from simply keeping the stocks. Additionally, funds that most heavily engaged in repurchasing behaviour underperformed funds that eschewed the practice. In other words, repurchase decisions are not guided by the manager having superior information.

Fear of regret

The study is just the latest to highlight how the fear of regret influences investors’ decisions. Reflecting on his 2011 research, Odean suggests that an investor who sells too early does not want to be reminded of his poor premature decision, so he “chooses to mentally distance himself from the stock by not repurchasing it”. Neuroscience research confirms this “regret aversion” predicts financial decision-making. In one 2016 study involving an experimental asset market, participants saw that a stock they had chosen not to buy had gone on to increase in price. This triggered neural activity in areas of the brain associated with emotional responses – a so-called “regret signal”. Participants were unwilling to repurchase stocks that had recently gained in price, the same study found, even though this led to “suboptimal” outcomes. Investor mistakes were “correlated with the neural measures of regret”, it noted. This regret aversion seems to be biologically hardwired into both humans and animals: recent research has shown that rats experience feelings of regret while mice actually change their behaviour in order to avoid regret, even if their new course of action does not lead to any tangible reward.

For investors, these findings have important implications. Fund managers’ emotion-driven practices are costing their investors – repurchased winning stocks go on to significantly underperform repurchased losing stocks, so investors’ aversion to the latter is costing them. Additionally, the biggest repurchasers, as noted earlier, underperform other funds. Funds would have made more money for their investors by simply keeping the stocks in their portfolios, while the extra trading costs further hurt performance.

Behavioural foibles

Ordinary investors should remember that while fund managers are often viewed as sophisticated types, they are clearly “subject to the same emotion-based biases as retail investors”, says Odean. Their behaviour, he adds, “deserves scrutiny as it has potentially negative effects on a large amount of investors”. Separate research shows fund managers are prone to other behavioural foibles such as home bias (overweighting portfolios with domestic stocks, resulting in insufficient diversification) and overconfidence.

In their defence, Odean notes research showing that fund managers are less prone than ordinary investors to other behavioural biases such as the disposition effect (the tendency to sell winners and hold onto losing stocks) and the attention bias (buying attention-grabbing stocks that are in the news). Behavioural finance is decidedly mainstream these days, and fund managers lap up the research from Nobel laureates such as Daniel Kahneman and Richard Thaler, but it's clear that overall, being aware of potential biases doesn't necessarily cure fund managers of them.

Importantly, the research finds that bringing other professionals on board does not mitigate emotional decision-making; rather, it exacerbates it, with team-managed funds actually 25 per cent more likely to be guilty of repurchasing bias. Consistent with other research into fund manager behaviour, it seems that group decision-making simply leads to groupthink.

It’s yet more evidence that ordinary investors should opt for passive funds that track markets rather than active funds that seek (in vain) to beat them, says Odean. Professional investors may be able to overcome certain common behavioural sins, but “emotion-based biases” clearly still impact their behaviour. Why? “Because they are probably the hardest to overcome.”