Perception of Extreme Returns Depends on Experience

The one-day returns an investor has previously experienced from any of the stocks they hold have a large effect on their selling behavior.

Investors are much more likely to sell their position when a stock’s one-day return is “extreme” compared to the one-day returns they have previously experienced. A one-day return is categorized as “extreme” when it’s viewed as very high or very low compared to the returns an investor has experienced before.

The finding is based on an analysis of portfolio-level trading data from over 6,000 investors who were clients of a major brokerage platform in the U.K. Researchers used the data to determine whether the way investors reacted to the returns generated by a stock they own depended on the magnitude of the returns they previously experienced in their portfolios.

Prior research suggested such a link exists. Particularly, previous studies have shown that the returns certain assets have generated in the past affect investors’ trading decisions. What those studies haven’t shown is whether past personal experiences with returns influence selling behavior. Researchers with the University of Warwick found it does.

A reason why has to do with the context effect: Sales are driven by the perception of the magnitude of the return rather than the objective magnitude of the return.

In discussing their findings, the study’s authors write: “Investors would take a given return as extreme if their experienced returns are mundane, while others would take it as normal if their own personal history of experienced returns is volatile … The context effect suggests that even the exact same returns of a stock could be perceived and interpreted in different ways due to different trading experiences.”

The context effect is stronger for some investors than others. Particularly, those who are older, hold more winning stocks in their portfolios and trade less show a stronger context effect.

Source: “It Depends Who You Ask: Context Effects in the Perception of Stock Returns,” by Constantinos Antoniou, Junyang Guo and Neil Stewart; Social Science Research Network, January 19, 2021.