Behavioral Biases and Investment

We investigate the way investors react to prior gains/losses. We directly examine investor reactions to different definitions of gains and losses (i.e., overall wealth, paper gains and losses, and realized capital gains and losses) and investigate how gains and losses in one category of wealth (e.g., real estate) affect holdings in other categories (e.g., financial assets). We show that investors change their holdings of risky assets as a function of both financial and real estate gains. Prior gains increase risk-taking, while prior losses reduce it. To interpret our results, we consider and compare three alternative hypotheses of investor behavior: prospect theory, house money effect and standard utility theory with decreasing risk aversion. Our evidence fails to support loss aversion, pointing in the direction of the house money effect or standard utility theory. Investors consider wealth in its entirety, and risk-taking in financial markets is affected by gains/losses in overall wealth, financial wealth, and real estate wealth. We appreciate the helpful comments of: O. Bondarenko, F. De Jong, B. Dumas, H. Hau, P. Hillion, R. Jaganathan, M. Lettau, P.Maenhout, M. Huang, S. Mullanaithen, T. Odean, J. Peress, R. Shiller, P. Sodini, M. Suominen, A. Subrahmanyan, B. Swaminathan, R. Thaler, L. Tepla, P. Veronesi, M. Weber and the participants of the Summer Financial Markets Symposium at Gerzensee and the NBER Behavioral Finance Meeting, Fall 2002. We are grateful to Sven-Ivan Sundqvist for numerous helpful discussions and for providing us with the data. Financial support from Inquiry Europe is acknowledged. Andrei Simonov also acknowledges financial support from the Jan Wallander and Tom Hedelius Foundation. Any remaining errors are our own.