An Experimental Approach

ESA World Meeting 2007, Rome

Marta MarasUniversitat Pompeu Fabra

The Disposition Effect in the Venture Capital Decision-Making Process

ESA World Meeting 2007, RomeJune 29, 2007

MOTIVATION

DISPOSITION EFFECT (Shefrin&Statman, 1985) Tendency of investors to retain losing investments in their

portfolios longer relative to their winning investments Extension of prospect theory (Kahneman&Tversky, 1979) to

investments

MY CONTRIBUTION Context of venture capital market (entry and exit investment

situations) Learning prior to decision making in experiments controlled

expertise Competitive environment (venture selection) Assessing costs and benefits of competition

ESA World Meeting 2007, RomeJune 29, 2007

LITERATURE REVIEW

DISPOSITION EFFECT (Shefrin&Statman, 1985) MARKETS

Stocks (Odean, 1998; Ranguelova, 2001), Stock options (Heath et al., 1999), Real-estate market (Genesove&Mayer, 2001), Futures (Heisler, 1994;

Locke&Mann, 1999) INVESTOR BEHAVIOUR

Above-average risks after losses (Coval&Shumway, 2005) Profitability of momentum trading strategy (Grinblatt&Han, 2001) Post-earnings announcement drift (Frazzini, 2006)

INVESTOR TYPE Individual vs. professional (Shapira&Venezia, 1998) Wealth, experience, trading frequency (Dhar&Zhu, 2005; Chen et al., 2004)

EXPERIMENTS Share positions automatically closed (Weber&Camerer, 1998); Locus of

control (Chui, 2001) Markets with different trading mechanisms (Oehler et al.,2002) Sunk costs&emotional commitment (Summers&Duxbury, 2005) Stability across tasks and time (Weber&Welfens, 2006)

ESA World Meeting 2007, RomeJune 29, 2007

EXPERIMENTAL DESIGN

DIAGRAM OF EXPERIMENTAL DESIGN PROCEDURE

NO COMPETITIONTREATMENT

LEARNING STAGE* MCPL TASK

CUE IMPORTANCERANKING

INVESTMENT STAGE*3 ROUNDS

COMPETITION

TREATMENT

ASSIGNMENTTREATMENT

VENTURE MANAGEMENT

VENTURE ASSIGNMENT

VENTURE SELECTION

VENTURE SELECTION

VENTURE MANAGEMENT

VENTURE MANAGEMENT

ESA World Meeting 2007, RomeJune 29, 2007

EXPERIMENTAL DESIGN

OPTIMAL INVESTMENT STRATEGY

t=0 t=1 t=2 t=3 t=4 t=5

ECU 1,000,000 ECU 800,000 ECU 600,000 ECU 400,000 ECU 200,000 PAYOFF

Venture Selection

Investment or Exit

Investment or Exit

Investment or Exit

Investment or Exit

Fund Closing

INVESTMENT STAGE – INVESTMENT PROCESS

Invest full amount provided in t=0 (no cash) in 2 ventures with best attribute values according to the cue model (due to upper bound on individual venture investment) Keep both in portfolio until t=5 by investing maximally in the more profitable venture

ESA World Meeting 2007, RomeJune 29, 2007

EXPERIMENTAL DESIGN

DISPOSITION EFFECT (Shefrin&Statman, 1985) Loss aversion is reflected in the significant difference

between proportion of gains realised (PGR) and proportion of losses realised (PLR)

PROPORTION OF GAINS REALISED =

PROPORTION OF LOSSES REALISED =

GAINS PAPER GAINSREALISED GAINSREALISED

LOSSESPAPER LOSSESREALISED LOSSESREALISED

Disposition Effect: PGR > PLR

ESA World Meeting 2007, RomeJune 29, 2007

RESULTS (1)

Relevance of prior learning and competitive environment on the selling behaviour of individuals that were previously not included in the experimental studies of the disposition effect

No clear evidence of Disposition Effect – behavioural pattern in accordance with standard economic theory General consistency in realising losses and apparent

heterogeneity regarding realisation of gains Lack of understanding of the experimental setting as a

possible reason for disposition effect emergence? Conflicting evidence in empirical studies (Feng and

Seasholes (2005), Dhar and Zhu (2005) & Genesove and Mayer (2001) vs. Chen et al. (2004))

Expertise Effect – Participants with higher levels of learning (reflected in judgement achievement components (ra, G and Rs)) had higher earnings in the experiment (investment stage)

ESA World Meeting 2007, RomeJune 29, 2007

RESULTS (2)

Participants held a more diversified portfolio and traded more often than optimal worsening their earnings

Treatment importance in selling behaviour influenced by the underlying return trends of portfolio ventures The decisions on holding or leaving the losing compared

to winning investments differ significantly conditional on the degree of competitive framing of the environment

Initial venture competition and interaction gave incentives for a more rational management of acquired ventures

Selling winners early decreases experimental earnings Competition participants significantly better at venture

management than No-Competition (t=2.48, p<0.02) and Assignment participants (t=-2.19, p<0.04)

ESA World Meeting 2007, RomeJune 29, 2007

RESULTS (2)

Optimal Strategy Analysis tracing reasons for earnings’ decreases

Learningb Consistencyc Managementd

NO COMPETITION 0.22 0.05 0.04 0.13

ASSIGNMENT 0.23 0.07 - 0.14

COMPETITION 0.34 0.10 0.18 0.07

Note: Sample size N=60. a comparison between the optimal and actual earnings of participantsb comparison between the optimal earnings and maximal earnings according to the participants' models from the learning stage (given optimal venture choices)c comparison between the maximal earnings given optimal venture choices according to the participants' models and maximal earnings given their actual venture choices. The comparison cannot be calculated for Assignment treatment due to venture assignment feature in period t=0.d comparison between the maximal earnings given actual venture choices of participants and their actual final earnings

Decrease due to

TREATMENT

Total Decrease

in Earningsa

ESA World Meeting 2007, RomeJune 29, 2007

THANK YOU!