How Prior Outcomes Affect Individual Investors' Subsequent Risk Taking

Abstract

We present empirical evidence of how prior outcomes affect individual investors’ subsequent risk taking. Investors who experience big gains or big losses are likely to exit the stock market; however, investors remaining in the market increase their portfolio risk taking following losses. They replace stocks sold with new positions of a higher (lower) value following recent losses (gains), thereby leading to an increase (decrease) in overall stock portfolio risk taking. Our results are consistent with the predictions of consumption habit formation interacting with the disposition effect. Our results cannot be explained by information, simple rebalancing, the house money effect, or the break even effect.

Keywords: risk taking, house money effect, break even effect, retail investors, individual investors, disposition effect

JEL Classification: G11