PROSPECT THEORY AND INVESTORS TRADING BEHAVIOUR MARKET. Philip Brown Gary Smith * Kate Wilkie. Abstract

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1 PROSPECT THEORY AND INVESTORS TRADING BEHAVIOUR IN THE AUSTRALIAN STOCK MARKET by Philip Brown Gary Smith * Kate Wilkie Abstract What, apart from taxation incentives and information arrival, explains inter-temporal change in market liquidity? We address this question from the perspective of prospect theory, which proposes that individuals are risk averse in the domain of gains and risk seeking in losses. We find that Australian investors prefer to realise gains earlier than losses and that in so doing their behaviour is more consistent with prospect theory than with alternative explanations arising from the taxation regime or from the traditional paradigm of rational choice. Key Words : Behavioural Finance, Prospect Theory, Market Liquidity, Australian Stock Market. JEL Classification : D81 *All of the University of Western Australia. Please address all correspondence to Gary Smith, Department of Accounting and Finance, The University of WA, 35 Stirling Highway, Crawley, WA, 6009; ; Phone ; Fax The authors would like to acknowledge the invaluable programming assistance of Ms Jennifer Cross.

2 PROSPECT THEORY AND INVESTORS TRADING BEHAVIOUR IN THE AUSTRALIAN STOCK MARKET

3 PROSPECT THEORY AND INVESTOR BEHAVIOUR REFERENCES Andreassen, P., 1993, The Psychology of Risk: A Brief Primer, Working Paper (The Jerome Levy Economics Institute of Bard College). Badrinath, S.G. and W.G. Lewellen, 1991, Evidence on Tax-Motivated Securities Trading Behavior, Journal of Finance 46, Barberis, N., M. Huang, and T. Santos, 1999, Prospect Theory and Asset Prices, Working Paper (University of Chicago and Stanford University). Beaver, W.H. 1968, The Information Content of Annual Earnings Announcements, Journal of Accounting Research 7, Benartzi, S. and R. Thaler, 1995, Myopic loss aversion and the equity premium puzzle, Quarterly Journal of Economics 110, Benge, M., 1998, Depreciation provisions and investment incentives under full imputation, Economic Record 74, Bremer, M. and K. Kato, 1996, Trading Volume for Winners and Losers on the Tokyo Stock Exchange, Journal of Financial and Quantitative Analysis 31,

4 PROSPECT THEORY AND INVESTOR BEHAVIOUR 29 Brown, P., D.B. Keim, A.W. Kleidon, and T.A. Marsh, 1983, Stock Return Seasonalities and the Tax-Loss Selling Hypothesis, Journal of Financial Economics 12, Campbell, J., and L. Hentschel, 1992, No news is good news: An asymmetric model of changing volatility in stock returns, Journal of Financial Economics 31, Campbell, J., S. Grossman, and J. Wang, 1993, Trading Volume and Serial Correlation in Stock Returns, Quarterly Journal of Economics 108, Cohen, M., J.Y. Jaffray, and T. Said, 1985,Individual behavior under risk and under uncertainty: an experimental study, Theory and Decision 18, Constantinides, G.M., 1984,Optimal Stock Trading with Personal Taxes: Implications for Prices and the Abnormal January Returns, Journal of Financial Economics 13, Ferris, S.P., R.A. Haugen, and A.K. Makhija, 1988, Predicting Contemporary Volume with Historic Volume at Differential Price Levels: Evidence Supporting the Disposition Effect, Journal of Finance 43, Hathaway, N.J. and R.R. Officer, 1996, The Value of Imputation Tax Credits, Working Paper (Melbourne Business School). Henderson, Y. 1990, Capital Gains Tax Rates and Stock Market Volume, National Tax Journal 43,

5 PROSPECT THEORY AND INVESTOR BEHAVIOUR 30 Hershey, J.C. and P.J.H. Schoemaker, 1980, Prospect Theory s Reflection Hypothesis: A Critical Examination, Organizational Behavior and Human Performance 25, Hsee, C.K. and E.U. Weber, 1999, Cross-National Differences in Risk Preference and Lay Predictions, Journal of Behavioral Decision Making 12, Kahneman, D. and A. Tversky, 1979, Prospect Theory: An Analysis of Decision Under Risk, Econometrica 47, Kogut, C.A. and O.R. Phillips, 1994, Individual decision making in an investment setting, Journal of Economic Behavior and Organization 25, Kumar, A., 1999, Behavior of Momentum Following and Contrarian Market Timers, Working Paper (Yale School of Management). Lakonishok, J. and S. Smidt, 1986, Volume for Winners and Losers: Taxation and Other Motives for Stock Trading, Journal of Finance 51, Lo, A. and A. MacKinlay, 1999, A Non-Random Walk Down Wall Street (Princetown University Press). McNichols, L. and P. O Brien, 1997, Self-selection and Analyst Coverage, Journal of Accounting Research 35,

6 PROSPECT THEORY AND INVESTOR BEHAVIOUR 31 Odean, T., 1998, Are Investors Reluctant to Realise their Losses?, Journal of Finance 53, Ritter, J.R., 1988, The Buying and Selling Behaviour of Individual Investors at the Turn of the Year, Journal of Finance 43, Schoemaker, P.J.H., 1980, Experiments on Decisions Under Risk: The Expected Utility Hypothesis (Martinus Nijhoff Publishing, Massachusetts). Shefrin, H. and M. Statman, 1985, The Disposition to Sell Winners Too Early and Ride Losers Too Long: Theory and Evidence, Journal of Finance 50, Sinha, T., 1994, Prospect theory and the risk return association: Another look, Journal of Economic Behavior and Organization 24, Thaler, R., A. Tversky, D. Kahneman, and A. Schwartz, 1997, The effect of myopia and loss aversion on risk taking: An experimental test, Quarterly Journal of Economics 112, Tkac, P.A., 1999, A Trading Volume Benchmark: Theory and Evidence, Journal of Financial and Quantitative Analysis 34, Tversky, A. and D. Kahneman, 1986, Rational Choice and the Framing of Decisions, Journal of Business 59, S251-S277.

7 PROSPECT THEORY AND INVESTOR BEHAVIOUR 2 3 Tversky, A. and D. Kahneman, 1992, Advances in Prospect Theory: Cumulative Representation of Uncertainty, Journal of Risk and Uncertainty 5, Weber, M. and C.F. Camerer, 1998, The disposition effect in securities trading: An experimental analysis, Journal of Behavior & Organization 33,

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