Benchmark-Based Preferences Make Investors Loss Averse in Bull Markets and Gain Seeking in Bear Markets

Abstract

Recent empirical studies have shown that investors are far more likely to be loss averse during bull markets than during bear ones. The aim of this short note is to give solid foundations to this empirical evidence. Using the benchmark-based preference method we establish a direct connection between the individual perception of the market trend and the individual risk preferences. Then we develop a novel definition of loss aversion and gain seeking which intuitively captures the human attitudes described by the quotes "losses loom larger than gains" and "gains loom larger than losses", respectively. Our findings have also practical applications. In fact they may offer a solid explanation to the disposition effect. According to this cognitive bias in bull markets investors are driven by loss aversion and tend to sell winners too early; whereas in bear markets investors are driven by gain seeking and tend to hold losers too long.