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Reference Price Adjustments for Winners and Losers

| | Posted in: Individual Investing

Do investors think differently about winning and losing positions? In their paper entitled “Why Do Investors Update Reference Prices Asymmetrically?”, Susan Grant, Ying Xie and Dilip Soman conduct four laboratory experiments to investigate differences in thought processes engaged by individual investors experiencing winning and losing investments. Using results of experiments involving 60-95 university students (mostly undergraduate) enrolled in business courses, they find that:

  • Investors are more likely to update investment reference prices for winners than losers.
  • This asymmetric updating of reference prices derives from the following tendencies:
    • Gains trigger a profit goal (selling mentality) and therefore active attention.
    • Losses trigger a goal of breaking even (holding mentality), with investors passively clinging to original purchase prices.
  • Consequently, investors have a more accurate memory of stock price trajectories for portfolio winners than losers.

The following chart, taken from the paper illustrates the asymmetric thinking associated with winning and losing investments. Investors tend (not) to update reference prices for assets on a positive (negative) price path.

In summary, evidence from laboratory experiments suggests that naive investors are more likely to update reference prices for portfolio winners than losers, promoting tendencies to sell the former and hold the latter.

Investors should perhaps update all portfolio positions on a regular schedule based on current price and expected return for each.

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