Professor of Finance
The author investigates the way investors react to prior gains/losses. The author directly examines investor reactions to different definitions of gains and losses (i.e., overall wealth, paper gains and losses, and realized capital gains and losses) and investigates how gains and losses in one category of wealth (e.g., real estate) affect holdings in other categories (e.g., financial assets).The author shows that investors change their holdings of risky assets as a function of both financial and real estate gains. Prior gains increase risk-taking, while prior losses reduce it.To interpret these results, the author considers and compares three alternative hypotheses of investor behavior: prospect theory, house money effect and standard utility theory with decreasing risk aversion.Evidence fails to support loss aversion, pointing in the direction of the house money effect or standard utility theory. Investors consider wealth in its entirety, and risk-taking in financial markets is affected by gains/losses in overall wealth, financial wealth, and real estate wealth.