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Behavioral Biases and Investment

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  • Massimo Massa
  • Andrei Simonov

Abstract

We investigate the way investors react to prior gains/losses. We directly examine investor reactions to different definitions of gains and losses (i.e., overall wealth, paper gains and losses, and realized capital gains and losses) and investigate how gains and losses in one category of wealth (e.g., real estate) affect holdings in other categories (e.g., financial assets). We show that investors change their holdings of risky assets as a function of both financial and real estate gains. Prior gains increase risk-taking, while prior losses reduce it. To interpret our results, we consider and compare three alternative hypotheses of investor behavior: prospect theory, house money effect and standard utility theory with decreasing risk aversion. Our evidence fails to support loss aversion, pointing in the direction of the house money effect or standard utility theory. Investors consider wealth in its entirety, and risk-taking in financial markets is affected by gains/losses in overall wealth, financial wealth, and real estate wealth.

Suggested Citation

  • Massimo Massa & Andrei Simonov, 2005. "Behavioral Biases and Investment," Review of Finance, European Finance Association, vol. 9(4), pages 483-507.
    • Handle: RePEc:oup:revfin:v:9:y:2005:i:4:p:483-507.
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    File URL: http://hdl.handle.net/10.1007/s10679-005-4998-y
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    1. Calvet, Laurent & Gonzalez-Eiras, Martín & Sodini, Paolo, 2004. "Financial Innovation, Market Participation, and Asset Prices," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 39(3), pages 431-459, September.
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    2. Deaves, Richard & Kluger, Brian & Miele, Jennifer, 2018. "An exploratory experimental analysis of path-dependent investment behaviors," Journal of Economic Psychology, Elsevier, vol. 67(C), pages 47-65.
    3. Haritha P H, 2024. "The Effect of Heuristics on Indian Stock Market Investors: Investor Sentiment as a Mediator," Management and Labour Studies, XLRI Jamshedpur, School of Business Management & Human Resources, vol. 49(1), pages 43-61, February.
    4. Abreu, Margarida & Mendes, Victor & Santos, João A.C., 2011. "Home country bias: Does domestic experience help investors enter foreign markets?," Journal of Banking & Finance, Elsevier, vol. 35(9), pages 2330-2340, September.
    5. Darren Duxbury & Robert Hudson & Kevin Keasey & Zhishu Yang & Songyao Yao, 2013. "How prior realized outcomes affect portfolio decisions," Review of Quantitative Finance and Accounting, Springer, vol. 41(4), pages 611-629, November.
    6. S, Ramya, 2023. "Analyzing the Impact of the Covid-19 Pandemic on Stock Market Investments," OSF Preprints wm4z3, Center for Open Science.
    7. Kylie J. Gilbey & Sharon Purchase, 2023. "Segmented financial risk tolerances within the standardised initial public offering regulatory environment of the Australian Securities Exchange," Accounting and Finance, Accounting and Finance Association of Australia and New Zealand, vol. 63(S1), pages 1447-1475, April.
    8. Shantha Gowri B & Vedantam Seetha Ram, 2019. "Does Availability Bias Have Influence on FMCG Investors? An Empirical Study on Cognitive Dissonance, Rational Behaviour and Mental Accounting Bias," International Journal of Financial Research, International Journal of Financial Research, Sciedu Press, vol. 10(4), pages 68-83, July.
    9. Chakravarty, Sugato & Ray, Rina, 2020. "On short-term institutional trading skill, behavioral biases, and liquidity need," Journal of Corporate Finance, Elsevier, vol. 65(C).
    10. Shashank Kathpal & Asif Akhtar & Asma Zaheer & Mohd Naved Khan, 2021. "Covid-19 and heuristic biases: evidence from India," Journal of Financial Services Marketing, Palgrave Macmillan, vol. 26(4), pages 305-316, December.
    11. Mattos, Fabio & Garcia, Philip & Pennings, Joost M.E., 2008. "Probability weighting and loss aversion in futures hedging," Journal of Financial Markets, Elsevier, vol. 11(4), pages 433-452, November.
    12. Cheung, Yan-Leung & Mak, Billy S.C. & Shu, Hao & Tan, Weiqiang, 2023. "Impact of financial investment on confidence in a happy future retirement," International Review of Financial Analysis, Elsevier, vol. 89(C).
    13. Xiao Ma & Seung Hyun Kim & Sung S. Kim, 2014. "Online Gambling Behavior: The Impacts of Cumulative Outcomes, Recent Outcomes, and Prior Use," Information Systems Research, INFORMS, vol. 25(3), pages 511-527, September.
    14. Christoph Merkle & Jan Müller-Dethard & Martin Weber, 2021. "Closing a mental account: the realization effect for gains and losses," Experimental Economics, Springer;Economic Science Association, vol. 24(1), pages 303-329, March.
    15. Mohammad Tariqul Islam Khan, 2022. "Prior perceived losses and investment objectives after stock market crisis: a moderated-mediation model of risk tolerance and loss aversion," SN Business & Economics, Springer, vol. 2(7), pages 1-22, July.
    16. Fenghua Wen & Zhifang He & Xu Gong & Aiming Liu, 2014. "Investors’ Risk Preference Characteristics Based on Different Reference Point," Discrete Dynamics in Nature and Society, Hindawi, vol. 2014, pages 1-9, April.
    17. Frieder, Laura, 2008. "Investor and price response to patterns in earnings surprises," Journal of Financial Markets, Elsevier, vol. 11(3), pages 259-283, August.
    18. Nawal Hussein Abbas Elhussein & Jarel Nabi Ahmed Abdelgadir, 2020. "Behavioral Bias in Individual Investment Decisions: Is It a Common Phenomenon in Stock Markets?," International Journal of Financial Research, International Journal of Financial Research, Sciedu Press, vol. 11(6), pages 25-36, December.
    19. Mizrach, Bruce & Weerts, Susan, 2009. "Experts online: An analysis of trading activity in a public Internet chat room," Journal of Economic Behavior & Organization, Elsevier, vol. 70(1-2), pages 266-281, May.
    20. Duxbury, Darren & Hudson, Robert & Keasey, Kevin & Yang, Zhishu & Yao, Songyao, 2015. "Do the disposition and house money effects coexist? A reconciliation of two behavioral biases using individual investor-level data," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 34(C), pages 55-68.
    21. Mattos, Fabio & Garcia, Philip & Pennings, Joost M.E., 2008. "Dynamic Decision Making in Agricultural Futures and Options Markets," 2008 Conference, April 21-22, 2008, St. Louis, Missouri 37605, NCCC-134 Conference on Applied Commodity Price Analysis, Forecasting, and Market Risk Management.
    22. Sharneet Singh Jagirdar & Pradeep Kumar Gupta, 2023. "Value and Contrarian Investment Strategies: Evidence from Indian Stock Market," JRFM, MDPI, vol. 16(2), pages 1-19, February.
    23. Mattos, Fabio & Garcia, Philip, 2009. "The Effect of Prior Gains and Losses on Current Risk-Taking Using Quantile Regression," 2009 Conference, April 20-21, 2009, St. Louis, Missouri 53035, NCCC-134 Conference on Applied Commodity Price Analysis, Forecasting, and Market Risk Management.
    24. Cao, Zhiqi & Lv, Dayong & Sun, Zhenzhen, 2021. "Stock price manipulation, short-sale constraints, and breadth-return relationship," Pacific-Basin Finance Journal, Elsevier, vol. 67(C).

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