Once Burned, Twice Shy: How Naive Learning and Counterfactuals Affect the Repurchase of Stocks Previously Sold

Abstract:     
We establish two previously undocumented patterns in the purchase selections of individual investors and confirm a related pattern. These patterns hinge on investors' previous experience with a stock. We demonstrate that investors prefer to: (1) repurchase stocks they previously sold for a gain rather than stocks they previously sold for a loss, (2) repurchase stocks that have lost value subsequent to a prior sale, rather than stocks that have gained value subsequent to a prior sale, and (3) purchase additional shares of stocks that have lost value since being purchased, rather than additional shares of stocks that have gained value since being purchased. We document these trading patterns by analyzing trading records for 66,465 households at a large discount broker between January 1991 and November 1996, and 665,533 investors at a large retail broker between January 1997 and June 1999. We propose that the first trading pattern results from a simple form of learning, whereby investors repeat actions that previously resulted in pleasure while avoiding actions that previously led to pain (i.e., they repurchase their previous winners more readily than their previous losers). We argue that the second and third trading patterns are tied to counterfactuals. Investors who buy a stock at a higher price than they previously sold it are painfully aware that they are worse off than if they had simply never sold that stock. Investors who buy a stock at a lower price than they previously sold it experience the pleasure of knowing they are better off than if they had never sold that stock. Investor returns do not reliably benefit from any of the three patterns we document.

Keywords: Behavioral finance, prospect theory, disposition effect, individual investors

JEL Classifications: G11, D1

Working Paper Series