Exploring whether gains and losses affect investors’ views on available investment options, the author finds that investors experiencing negative outcomes are more likely to develop larger-than-normal pessimistic views. She also finds that investors in this so-called negative domain have larger errors in their beliefs regarding the quality of investments than when operating in a positive domain.
What’s Inside?
The author focuses on investors’ reactions to positive and negative news and how those situations affect their investment decisions. She finds that individuals in the negative domain (i.e., experiencing losses) form more pessimistic views on financial investments than individuals in the positive domain (i.e., experiencing gains). These beliefs are driven by individuals’ exposure to negative experiences within the market.
How Is This Research Useful to Practitioners?
Most financial industry practitioners are aware of studies showing that investors place more weight on losses than on an equal amount of gains. The author expands that research by incorporating how people use experiences to form their current beliefs on investing. She finds that individuals within the negative domain form more pessimistic views on particular investments than those in the positive domain, especially for those who are actively investing versus passively investing.
Additionally, the author finds that individuals in the negative domain have larger errors in their beliefs regarding whether an investment is good or bad. She looks at various samples both within and outside the United States. Risk preferences of various individuals also do not play a factor in the study’s outcomes. The author’s conclusions are representative of the investor universe as a whole, and she shows that, in fact, negative news and investment outcomes do affect available investment decisions and beliefs.
This study is beneficial for financial professionals. It helps support the ideas that events and news affect investors’ financial behavior and decisions and that advisers must understand their clients in order to develop a proper investment strategy for them. Additionally, the research could help investment professionals better understand market conditions in times of stress or volatility with the knowledge that investors will focus on negative events when making investment decisions.
How Did the Author Conduct This Research?
The author studies 87 individuals (37 men, 50 women) from Northwestern University located in Evanston, Illinois. She also conducts a replication study on an out-of-sample group to validate the in-sample findings. The out-of-sample study is conducted at Babeș-Bolyai University in Romania, with a sample size of 203 individuals (53 men, 150 women).
Each participant completes two financial decision-making tests—one active and one passive. The order of the tests is decided randomly. During these tests, information regarding two securities (a stock and a bond) is presented. There is a gain or a loss payout. Gain payouts provide positive results, whereas loss payouts provide negative results. Additionally, the stock pays either good dividends (70% chance of high payout) or bad dividends (70% chance of low payout). Each individual participates in 60 trials of both the active and passive tests.
In the active test, individuals decide which security to invest in (stock or bond) and provide an estimated probability that the stock is paying good dividends. In the passive test, individuals only need to provide an estimated probability that the stock is paying good dividends.
The author finds that investors focus more on negative experiences than positive ones when making current investment decisions. These observations are consistent across both the in-sample and out-of-sample studies. Additionally, they are not affected by differences in risk tolerance. The author demonstrates that these situations help drive investors’ investment decisions.
She also successfully eliminates all limitations to the research. Females represent the majority of each study. It may be beneficial to conduct two separate studies, one consisting of only men and one consisting of only women, to see whether the two groups act differently from one another. The results of that research could help advisers further adapt investment strategies and presentations to each gender.