Prospect Theory and Institutional Investors

Abstract

There is ample evidence that past performance affects the trading decisions of individual investors. This paper looks at this issue using a detailed database of currency trading decisions of institutional investors. Past performance manifestly affects currency risk-taking in this group, but the sign and magnitude of the effect runs counter to much of the existing theory and evidence. There is no evidence whatsoever of disposition effects; rather, the dominant characteristic is aggressive risk reduction in the wake of losses. This effect is more prominent later in the year, and among older and more experienced funds. A modified version of the loss aversion model of Barberis, Huang and Santos (2001) offers the best hope of adequately accounting for the observed behavior.

Keywords: institutional investors, past performance, loss aversion

JEL Classification: G10, G11, G30