Influence of endogenous reference points on the selling decisions of retail investors

Abstract

We examine the influence of the endogenous reference points on the selling decisions of investors in financial markets. The realized outcome and the counterfactual maximum are known to shape the reference formation of the decision-makers. Therefore, we investigate whether endogenous stock-specific reference points, ‘realized-return’, and ‘peak-return’ of the previous round of investment in a stock significantly influence the selling propensity when they repurchase the same stock, using trader-level data of stock investments. We find that the selling propensity rises significantly when the return in the repurchase round is close to the ‘realized-return’ and the ‘peak-return’ of the previous round. The results imply that the past stock-specific experience significantly influences reference formation. Furthermore, the influence of the reference points is greater for traders with a relatively short holding period. The influence of endogenous reference points also declines with the time between the consecutive rounds of investment in the same stock. Since traders are known to exhibit the recency effect, the findings suggest that traders attach lower decision weights to the stock-specific endogenous reference points with time. The stock-specific reference points have a greater impact on the decisions of traders holding concentrated portfolios than diversified portfolios, likely due to the lower division of attention when traders hold fewer stocks. The findings suggest that endogenous reference points shaped by context-specific memory have a significant influence on the trading decisions of market participants.