Fully Closed: Individual Responses to Realized Gains and Losses

Abstract

We use transaction-level data of portfolio trades and holdings linked to checking, savings, and settlement account transactions and balances to explore how individuals respond to realized capital gains and losses. We exploit plausibly exogenous sales due to mutual fund liquidations for identification. Specifically, we estimate the marginal propensity to reinvest out of one dollar received from a forced liquidation, when the investor either achieved a gain or a loss relative to his or her initial investment. Theoretically, if individuals held optimized portfolios, the marginal propensity to reinvest out of forced sales should be 100%. Individuals should just reinvest all of their liquidity immediately into a fund with similar characteristics. Empirically, individuals reinvest 83% on average if the forced sale resulted in a gain, but only 40% in the event of a loss. If individuals do not reinvest, they keep a share of their newly found liquidity in cash, save it, or consume it. Such differential treatment of gains and losses is inconsistent with active rebalancing or tax considerations, but consistent with mental accounting and the idea that individuals treat realized losses differently than paper losses. We thus provide evidence for realization utility and effects (Barberis and Xiong, 2012; Imas, 2016) and that individuals do not appear to learn rationally from experiences in the stock market (Malmendier and Nagel, 2011; Koudijs and Voth, 2016).