October, 30th, 2018
"Fully Closed: Individual Responses to Realized Capital Gains and Losses“
We use transaction-level data of portfolio trades and holdings linked to checking, savings, and settlement account transactions and balances to explore how individuals respond to realized capital gains and losses. To identify the effects of realized gains and losses, we exploit plausibly exogenous mutual fund liquidations. Specifcally, we estimate the marginal propensity to reinvest one dollar received from a forced sale event, when the investor either achieved a capital gain or a loss relative to his or her initial investment. Theoretically, if individuals held optimized portfolios, the marginal propensity to reinvest out of forced liquidations should be 100% independent of realizing a gain or a loss. Individuals should just reinvest all of their liquidity immediately into a fund with similar characteristics. Empirically, individuals keep a share of their newly found liquidity in cash, save it, consume it, or reinvest it into different funds, stocks, or bonds. Moreover, individuals reinvest 80% if the forced sale resulted in a capital gain, but only 40% in the event of a loss. Such differential treatment of gains and losses is inconsistent with active rebalancing or tax considerations, but consistent with mental accounting and the idea that individuals treat realized losses differently from paper losses. We thus provide evidence for realization utility and effects (Barberis and Xiong, 2012; Imas, 2016) and argue that individuals do not appear to learn rationally from experiences in the stock market.