An Investor Behavior and Related Asset Pricing Distortions

Abstract

I document a stylized fact about stock buying behavior of investors. I empirically show that investors tend to buy riskier stocks following a realized loss. The risk measure that the investors seem to pay attention to is the market beta of the stocks. Thus, after a realized loss, investors buy higher beta stocks. This behavior 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 pricing distortions in a direction similar to the beta anomaly. With this insight, I suggest a modification to the betting against beta trading strategy that can improve the Sharpe ratio more than twofold.