Title: INVESTOR DISPOSITION EFFECT ON INVESTMENT DECISION MAKING: AN EXPLANATION OF REGRET REGULATION AND REGULATORY FOCUS

Authors: I Made Surya Negara Sudirman

Item Type : Thesis (Thesis)

Affiliations: Doctoral Study Program in Management Science, Faculty of Economics and Business, Universitas Airlangga , Surabaya, Indonesia

Publisher: Universitas Airlangga

Abstract

The disposition effect is the tendency of investors to sell superior-performing stocks early and hold inferior-performing stocks too long (Shefrin and Statman, 1985). The disposition effect has become a widely studied phenomenon because it results in the loss of potential profits that investors can obtain when stock prices are still rising, and the potential for greater losses that investors will suffer when stock prices continue to decline. Various different explanations have been offered by previous researchers, but to date, several questions remain unanswered. Prospect theory (Kahneman and Tversky, 1979) and regret theory (Loomes and Sugden, 1982; Bell, 1982) are the two theories most widely used by researchers to explain the disposition effect phenomenon. Prospect theory provides an explanation based on the concept of loss aversion, while regret theory provides an explanation based on the concept of anticipated regret. Loss aversion causes investors to sell superior-performing stocks too early, and loss aversion causes investors to hold inferior-performing stocks too long. Anticipation of regret leads investors to prematurely sell superior-performing stocks, while anticipation of regret leads investors to hold onto inferior-performing stocks for too long. While both theories adequately explain the disposition effect, they both have weaknesses, leaving several questions unanswered. Prospect theory and regret theory fail to answer several questions, including: What conditions determine investors' premature sale of superior-performing stocks? Does every price increase always lead investors to sell their superior stocks? What conditions determine investors' prolonged holding of inferior-performing stocks? Are investors still willing to hold onto inferior stocks when price declines continue, resulting in increasingly greater losses? (Sudirman, et. al. 2017) To answer these questions, a theoretical model in this study was constructed by considering: regulatory focus, gain rate, loss rate, and stock price volatility. This research model is based on Regret Theory (Loomes and Sugden, 1982; Bell, 1982). Regret Regulation Theory (Zeelenberg and Pieters, 2007; Pieters and Zeelenberg, 2007); Regulatory-Focus Theory (Higgins, 1997;1998) and several hypotheses, including: Leverage Effect Hypothesis (Black, 1976; Christie, 1982); Volatility Feedback Hypothesis (Pindyck, 1984; French et al. 1987). In this study, two models were built, namely model 1 and model 2. Model 1 is a model that explains the main effects and interaction effects between variables that have consequences on the disposition effect in the gain domain. Model 2 is a model that explains the main effects and interaction effects between variables that have consequences on the disposition effect in the loss domain. The research method used in this study is a true experimental, conducted in the laboratory, with a 2x2x2 mixed factorial design for each model, model 1 and model 2. The mixed factorial design in this study consists of one between-subject factor and two within-subject factors. Model 1 consists of: the regulatory focus factor as a between-subject factor, and the gain level and volatility level factors as within-subject factors. Model 2 consists of: the regulatory focus factor as a between-subject factor, and the loss level and volatility level factors as within-subject factors. The sample in this study amounted to 60 participants for each model, which was selected using a simple random sampling method, by previously determining the target population and the accessible population. Data analysis in this study used a mixed three-way ANOVA (ANOVA), which is a complex model ANOVA to analyze models consisting of one between-subject factor and two within-subject factors. Post hoc tests in this study were conducted using the Bonferroni Test. The results of this study indicate that the regulatory focus factor, gain level, loss level, and volatility level influence differences in the level of investor disposition effect. The main effects of regulatory focus, gain level, and volatility level indicate that these three factors significantly determine the level of disposition effect in the gain domain. The main effects of regulatory focus, loss level, and volatility level indicate that these three factors significantly determine the level of disposition effect in the loss domain. Individually, the gain level and loss level are the main factors that can largely explain the variability of the disposition effect. The three-way interaction effect between the type of regulatory focus, gain level, and volatility level produces a unique effect in model 1. The unique interaction effect in model 1 explains that promotion-focused investors tend to choose risky options when the gain level is low and the volatility level is low, which results in a decrease in the disposition effect. Conversely, when the gain level is high and the volatility level is high, promotion-focused investors tend to choose less risky options, which results in an increase in the disposition effect. The unique interaction effect in model 1 also explains that prevention-focused investors are more susceptible to the disposition effect than promotion-focused investors when the gain level is small and the volatility level is low. Conversely, when the gain level is large and the volatility level is high, promotion-focused investors are more susceptible to the disposition effect than prevention-focused investors. The three-way interaction effect between regulatory focus type, loss level, and volatility level produces a unique effect in model 2. The unique interaction effect in model 2 explains that prevention-focused investors tend to choose risky options when loss levels are low and volatility levels are low, which results in an increase in the disposition effect. Conversely, when loss levels are high and volatility levels are high, prevention-focused investors choose less risky options, which results in a decrease in the disposition effect. The unique interaction effect in model 2 also explains that prevention-focused investors are more susceptible to the disposition effect than promotion-focused investors when loss levels are small and volatility levels are low. Conversely, when loss levels are large and volatility levels are high, promotion-focused investors are more susceptible to the disposition effect than prevention-focused investors. The results of this study provide a more sophisticated explanation of the disposition effect, by answering questions that have not been answered in previous theoretical explanations. In addition to providing a more sophisticated theoretical explanation than previous studies on the causes of the disposition effect, this study also has theoretical implications for a new paradigm regarding risk preference as a tactic. In conventional finance based on expected utility theory, risk preference is viewed as a trait, and every investor is assumed to be risk averse. In behavioral finance based on prospect theory, risk is viewed as a trait determined by prospects. Prospect theory states that in favorable prospects or the gain domain, investors are risk averse, while in unfavorable prospects, the loss domain, investors are risk seekers. In this research's theoretical model, which is based on Regret Theory, Regret Regulation Theory, Regulatory Focus Theory, and several hypotheses, including the Leverage Effect Hypothesis and the Volatility Feedback Hypothesis, risk preference is viewed as a tactic. Where in the gain and loss domains, investors can choose risk aversion and risk seeker tactics, depending on the type of regulatory focus they have and the conditions faced. Promotion-focused investors have regulatory fit in the gain domain, tending to anticipate regret by choosing risk-seeking tactics when expected profits have not been achieved. Conversely, promotion-focused investors tend to anticipate regret by choosing risk-aversion tactics when expected profits have been achieved. Prevention-focused investors have regulatory fit in the loss domain, tending to anticipate regret by choosing risk-seeking tactics when the losses suffered are still tolerable. Conversely, prevention-focused investors tend to anticipate regret by opting for risk aversion when losses become intolerable. This research's key novel contribution is the cutting-edge explanation of the disposition effect and the new paradigm surrounding risk preferences. This research is expected to contribute to the development of behavioral finance, develop best practices for capital market practitioners, and serve as a basis for consideration by capital market regulators in formulating policies.

Keywords: disposition effect, regulatory focus theory, regret regulation theory, regret theory

Sources: http://repository.unair.ac.id/77388/