The Asymmetric Rank Effect for Winning and Losing Portfolios

Abstract

This paper shows that patterns which prior literature has attributed to preferences for selling extreme-ranked positions (rank effects) can be traced to different responses of investors when their portfolio performance fluctuates over time. I show that when investors face poorly performing portfolios, they are predisposed to liquidate their best stocks; otherwise, their rank preferences attenuate and show some shift towards selling their worst positions. These findings are consistent with investors becoming more risk averse after observing underperforming portfolios. The results shed light on two prominent anomalies, the excess volatility of returns, and the equity premium puzzle.