Are Out-of-Pocket Costs Overweighted Relative to Opportunity Costs? A Disposition Effect - Based Investigation

Abstract:     
In theory out-of-pocket or actual costs and opportunity costs of a decision should be treated equivalently in the decision-making processes of an individual. Is this normative prescription observed in practice? Though this is a fundamentally important economic question, it has so far remained unsettled. In this paper we conduct formal tests to settle the question, using an innovative empirical methodology and a very large sample of trading and investment decisions of investors in Indian stock markets for our data. Our strategy involves comparing the behavioral biases the investors exhibit in two classes of decisions: selling stocks that they already own and repurchasing stocks that they held in the past but currently do not. The first set of decisions are driven by actual costs and gains and the second set by opportunity costs and gains. Our tests consistently show that that the disposition to sell stocks is stronger for the average investor than the disposition to repurchase stocks, suggesting that the investors overweight actual costs and gains relative to opportunity costs and gains. While both disposition biases lead to negative stock market outcomes for the investors after controlling for the effects of excessive trading and market movements, the average investor loses more from the disposition to sell than from the disposition to buy. We also find that more sophisticated, wealthy and skillful investors are less prone to both biases.

Number of Pages in PDF File: 50

Keywords: individual investors, trading behavior, disposition effect, opportunity costs, out-of-pocket costs

JEL Classification: D19, G14

working papers series