Higher stakes lead to worse stock performance, research finds
Conventional wisdom notes that people make better decisions when incentivized, but new research finds that doesn’t hold when it comes to stock market investments.
GAINESVILLE, Fla. – Imagine you are walking down the street, and someone stops you to ask this question: You bought a stock at $30 per share. Now, the stock’s price is $15. Under which scenario are you more likely to sell the stock – if you bought one share or if you bought 1,000 shares?
If you said you’d be more likely to sell if you had only bought one share, then you’d be in the majority. The behavior is a well-known investor bias called the disposition effect, which is the tendency to sell winning stocks too early and hold losing stocks too long.
This example highlights the findings of new research from the University of Florida. The paper, “Stocks and Investor Behaviors,” finds that despite the potential to make or lose significant sums of money in the stock market, stakes play an unconventional role in investor behavior. Specifically, as highlighted in this example, higher stakes increase investor bias, leading to worse performance.
Bank of America Associate Professor of Finance Baolian Wang
“The conventional wisdom is that people can make better decisions when they are more incentivized, i.e., when stakes are higher,” explained Baolian Wang, Bank of America Associate Professor of Finance and research author. “If experimental subjects are properly incentivized, any mistakes they might have made before being incentivized would disappear or be significantly muted. Our findings suggest that it may not hold when we talk about the stock market.”
In their study, Wang and his co-author Pengfei Sui of Chinese University of Hong Kong (Shenzen) followed the portfolio success of investors who had two brokerage accounts, one that used their real money and another in a simulated setting with no real money involved.
In the investors’ real accounts, the researchers noted stronger behavioral biases, including this standard set of well-known investor biases:
- Disposition effect – a stronger tendency to sell stocks that earn capital gains than to sell those that incus capital losses
- Lottery preferences – buying lottery priced stocks, which are lower-priced, more volatile and more positively skewed than non-lottery stocks
- Extrapolation – buying stocks with high past returns
- Underdiversification – holding smaller sets of stocks in portfolios
- More trading
These behaviors all add up to worse performance in investors’ real accounts than in their simulated accounts.
Given the results of the study, Wang notes that investors should understand that effort and attention can be counterproductive in some scenarios.
“If you want invest more or spend more time on investment, there is no guarantee that you will do better,” he said. “Quite the opposite, you may do worse. I do not suggest that you completely ignore your investments or stay out of the stock market, but it’s better not to assume that more effort and higher attention will improve performance in the stock market.”
Instead, Wang recommends that investors consider the following three suggestions for better performance:
- Study and understand the well-known investor biases.
- If you tend to hold any of the biases, be aware that these can be costly either because of incorrect beliefs about the stock market or because of non-traditional preferences (like the gambling preference).
- If you exhibit any of these biases, be extra cautious when considering your investments.
