Koustav De is Assistant Professor in Finance at the Gatton College of Business & Economics, University of Kentucky.
Area of Interest:
Behavioral Finance (investor behavior)
Gatton College of Business & Economics,
University of Kentucky.
Using trading data from Finland and the US, I empirically show that investors tend to buy riskier stocks following realized losses. The measure of risk that the investors seem to pay attention to is the market beta of a stock. This behavior of buying higher beta stocks after a realized loss is observed in institutional as well as individual investors, but is more pronounced among individual investors with lower expertise, who on an average buy a new stock with up to 15% higher beta than that of the old stock they were holding. For an agent with utility consistent with prospect theory, this behavior emerges as the optimal response to her problem of maximizing utility within a mental account. Furthermore, this behavior can aggregate up during market downturns and cause return predictability in high beta stocks. With this insight, I suggest a modification to the betting against beta trading strategy that can improve the Sharpe ratio more than twofold.