Blog - Investing Notes

September 2, 2005 – Channeling the Ghosts of Stocks Past

In their September 2004 paper entitled "Once Burned, Twice Shy: How Naive Learning and Counterfactuals Affect the Repurchase of Stocks Previously Sold", Terrance Odean, Michal Strahilevitz and Brad Barber examine how past experience with a stock affects the average investor's subsequent actions regarding that stock. Using trading records for 66,465 households at a large discount broker during 1991-1996 and 665,533 investors at a large retail broker during 1997-1999, they show that the average investor tends to:

• Repurchase stocks previously sold for a gain rather than stocks previously sold for a loss, thereby repeating (avoiding) actions that previously resulted in pleasure (pain);
• Repurchase stocks that have lost value since a prior sale rather than stocks that have gained value since a prior sale, thereby reinforcing (avoiding) a feeling that the prior sale was a good (bad) decision; and,
• Purchase additional shares of stocks that have declined since being acquired (average down) rather than additional shares of stocks that have advanced since being acquired, thereby capturing (avoiding) a feeling of getting (have missed) a bargain.

None of these three tendencies reliably improve investment returns. Nor are they tax-driven.

All of these tendencies are contrary to the general preference of investors for buying stocks with strong recent performance (momentum).

In summary, individual investors should exercise special care when considering the repurchase of stocks previously owned or the purchase of more of stocks already owned to ensure that their intellects are in charge of their feelings.

For other research related to individual investor behaviors and performance, see our blog entries of:

8/10/05 examining whether individuals are big picture (portfolio-optimizing) or little-picture (single stock optimizing) investors;

6/21/05 on the detrimental behavior of investors regarding attention-grabbing stocks;

5/11/05 regarding the transfer of wealth from active individual traders to companies issuing or buying back stock;

4/16/05 for links between psychological factors and performance for day-traders;

3/28/05 for a summary of behavioral finance;

3/16/05 regarding outperformance of savvy, underdiversified individual investors;

2/6/05 pitting individual investors against rational speculators around attention-grabbing events (guess who wins);

12/14/04 on whether individual investors should value the stock weightings of mutual fund managers in assembling their portfolios;

10/30/04 regarding the implicit coordination of individual investors in buying and selling stocks;

10/29/04 on the hazards of overtrading for individual investors; and,

10/22/04 for an analysis of whether day-traders make money.