Agitated Losses and Relaxed Gains

Abstract

One of the robust regularities of stock markets is the asymmetric relation between stock returns and their subsequent volatility, commonly referred to as the 'leverage effect'. In the current paper we present a psychological model linking between gains and losses, choice volatility, and market prices of publicly traded stocks, based on a recent attentional model of losses, that accounts for this effect as well as some other regularities of the stock market. The attentional effect of losses implies greater exploratory search behavior and therefore more choice volatility (i.e., incidents of switching between choice options) following monetary losses. Our study begins with an empirical examination using an abstract experiential task. We find increased choice volatility in tasks with losses compared to tasks with no losses, and that this heightened volatility is maintained even in subsequent tasks that do not include losses. Conversely, gains are found to have an opposite 'relaxing' effect on choice volatility. Both phenomena are observed even in the absence of loss aversion. We follow with an agent based model of the stock market and demonstrate that embedding a simple increase in choice volatility following losses compared to gains yields increased price volatility subsequent to losses, while also providing sufficient conditions for four other major stock market regularities in a unified framework.