By Amin Zokaei Ashtiani
Introduction
Studies have shown that during a stock market crash when the share prices plummet, many investors’ first reaction is to rush to sell their shares. This wide-scale selling of stocks is what has been called “panic selling”. This not only aggravates the market crash through a spiraling effect, but also negatively affects the balance sheets of stock market participants through the allocation of risk.
The larger part of the growing body of literature that studies panic selling has so far concentrated mostly on uncovering its roots and causes. Several factors have been introduced as causes, namely loss aversion, overconfidence, regret aversion, trend-following bias, and confirmation bias. However, in cases like this, where a financial behavior is conditioned by deep-seated cognitive biases, the mere uncovering of causes is not likely to help solve the problem. As it has been suggested by Thaler and Sunstein, in order to ensure a more rational behavior on share holders’ part during a market crash, an intervention is necessary. They call this positive intervention in the decision-making process a nudge.
In a study that I conducted with my colleagues Marc Oliver Rieger and David Stutz, we introduced and tested a new nudge made up of a combination of the endowment effect and the IKEA effect. We found that when investors are given the chance to choose their own regional Exchange-Traded Funds (ETF), they are more likely to stick with their asset allocations during a crash in comparison to a scenario where asset allocation has been delegated to a financial advisor.
The endowment effect is a phenomenon whereby “people often demand much more to give up an object than they would be willing to pay to acquire it”. This effect exemplifies a higher inclination towards keeping the present state of affairs, and thereby can be called a status quo bias. This preference generally inclines people against trade and exchange.
The IKEA effect is “the increase in valuation of self-made products”, which has also been called the “I designed it myself” effect. The added valuation has to do with the gratifying of a psychological need to show off one’s capability to oneself as well as to others.
Both in the endowment effect and the IKEA effect, people tend to attach an additional value to their belongings: in the former case to what they own in comparison to what they can acquire, and in the latter, to what they have made themselves. In neither case can the added value be rationally justified. In the context of the stock market, the endowment effect can make people unwilling to sell their presently owned shares, while the IKEA effect can augment the effect in case of a self-made portfolio.
We tested this idea by giving the investors the chance to choose regional areas for investment. Our hypothesis was that they will be more likely to stick with their investment choices during a market crash or to sell a smaller portion of their shares compared to investors who used the services of a financial advisor. We interpret the extra value attached to the portfolio and the constancy in keeping the shares to be a result of the endowment effect and the IKEA effect combined.
Experiment
In the first part of a computer-based experiment, we asked 219 participants to invest their imaginary money in risky and risk-free assets. In the second part, the participants were divided into two groups. In the first group, the non-advised group (N=95), the participants were given the chance to choose their own regional portfolio whereas the second group, the advised group, had their portfolios assembled for them. Finally, in the third part the participants’ reactions to a market crash were elicited using a scenario in which a year after the investment, the total value of the portfolio drops by 20%. The participants were asked whether they would increase or decrease their equity exposure and by how much.
Results
Our results showed that after a market crash, investors with self-made portfolios, males, and investors majoring in business on average show more commitment and are in statistical terms significantly less likely to sell their risky assets. More precisely, 31% of the participants in the advised group decided to sell their risky assets, whereas only 10% of the participants with self-made portfolios opted for reducing their risky assets.
Differences in Proportions of Asset Sellers Across Groups
Difference between | Proportion of Asset Sellers Difference (in %) |
|---|---|
| Advised and Non-advised | 21 |
| Non-experienced and Experienced | 7 |
| Female and Male | 25 |
| Older than 30 and Younger than 30 | 5 |
| Low income and High income | 4 |
| Non-degree and Degree | 2 |
| Non-business student and Business student | 14 |
| Low saver and High saver | 3 |
| High loss averse and Low loss averse | 4 |
| Low regret aversion and High regret aversion | 8 |
| High NFC score and Low NFC score | 1 |
We conclude that the effect of our nudge is strong. Our data showed that the effect is of an even larger magnitude than the difference between an inexperienced and an experienced investor. It also has a stronger effect than differences in behavioral preferences that might contribute to panic selling like loss aversion and regret aversion.
Diversification
The loss of diversification in regional ETFs might be a source of concern as it could be claimed to increase the risks for investors. In our experiment such concerns can be valid for the non-advised group who chose their portfolios from 4 to 8 regional ETFs. One might wonder whether the gains of avoiding panic selling can actually surpass losses posed by lower diversity. However, despite the fact that loss of diversification can be a potential issue for our nudge, we believe that while investing in regional ETFs such losses hardly pose any additional risk because of a great degree of correlation and financial contagion between international capital markets especially during crises.
Nonetheless, we also measured 1-year and 3-year returns and volatilities for each portfolio that the participants in the non-advised group had put together and compared these values to the “anti-nudging” portfolio (advised group). The results showed no significant decrease in risk-adjusted performance through nudging. We conclude that loss of diversification, even in the case of inexperienced investors and those not majoring in business who might be most vulnerable to mistakes caused by their own investment decisions, has not led to an increased risk for the investors.
Conclusion
The main idea of our research can be understood as fighting fire with fire: using potentially harmful behavioral biases (a combination of IKEA effect and endowment effect) in order to fight an even more dangerous problem – panic selling. In our experiment, we could reduce panic selling by using a simple nudge that strengthens the psychological connection between a portfolio of assets and its owner: to achieve that, we simply let subjects contribute to the selection process of the assets.
