Trading performance, disposition effect, overconfidence, representativeness bias, and experience of emerging market investors

Abstract

Using brokerage account data from China, we study investment decision making in an emerging market. We find that Chinese investors make poor trading decisions: the stocks they purchase underperform those they sell. We also find that Chinese investors suffer from three behavioral biases: (i) they tend to sell stocks that have appreciated in price, but not those that have depreciated in price, consistent with a disposition effect, acknowledging gains but not losses; (ii) they seem overconfident; and (iii) they appear to believe that past returns are indicative of future returns (a representativeness bias). In comparisons to prior findings, Chinese investors seem more overconfident than U.S. investors (i.e., the Chinese hold fewer stocks, yet trade very often) and their disposition effect appears stronger. Finally, we categorize Chinese investors based on proxy measures of experience and find that ''experienced'' investors are not always less prone to behavioral biases than are ''inexperienced'' ones. key words disposition effect; investor behavior; overconfidence; representativeness biasThis study considers the extent to which Chinese investors make poor trading decisions and exhibit three particular behavioral biases: (a) the disposition effect, (b) overconfidence, and (c) the representativeness bias. These cognitive errors are forms of heuristic simplification, which stem from the brain's tendency to make mental shortcuts rather than engaging in longer analytical processing. The tendency for people to suffer from these biases is well-established in the psychology and behavioral science literature (e.g. Disposition effectConsider the situation in which an investor wishes to sell a stock. The investor can sell a stock that has increased in price or one that has decreased in price. People avoid actions that create regret and seek actions

The value of financial advice: An analysis of the investment performance of advised and non-advised individual investors

“…Thus, in their study using a comprehensive dataset from Finland, Grinblatt and Keloharju found that it is overconfident investors who were most prone to sensation-seeking and therefore traded more frequently. This frequent trading exposes investors to higher levels of risk, increased transaction costs and consequently lower total returns (Chen, Kim, Nofsinger & Rui, 2007).…”

“…Chen et al (2007) claim that " [p]eople avoid actions that create regret and seek actions that cause pride". Therefore, selling a stock that has increased in value, also referred to as a winner, is a form of validation to an investor for the good decision made in purchasing the stock in the first place.…”

“…Therefore, selling a stock that has increased in value, also referred to as a winner, is a form of validation to an investor for the good decision made in purchasing the stock in the first place. Similarly, to sell a stock that has decreased in value, in other words, a loser, would indicate that the original decision to purchase was poor and therefore causes regret (Chen et al, 2007). Shefrin and Statman (1985) also found that investors tend not to sell losers as they are afraid that the stock may recover, thereby causing further regret.…”

“…The investor therefore tends to keep track of gains and losses of individual stocks rather than on a portfolio level (Shefrin & Statman, 1985;Thaler, 1980). The disposition effect is therefore a combination of principles of the prospect theory and mental accounting, to predict that investors are more willing to sell winners than losers in their portfolios (Chen et al, 2007).…”

Behavioral Finance: History and Foundations

“…For instance, using brokerage account data from China, Chen et al (2007) found that more than 40% of individual and 58% of institutional investors show evidence of more than one behavioral bias. While analyzing Swedish data, Anderson (2007Anderson ( , 2013 documented that a low-income, less wealthy, less educated, and less sophisticated investor is more prone to have a less diversified portfolio, trades relatively more, and achieves worse trading results.…”