Do Investors Hedge Against Embarrassment?

Any competitive environment bears some cynicism in how competitors carry themselves. For example, a group of economists from the University of Chicago proposed that professional soccer players choose a strategy during penalty kicks that are more rooted in their self-image rather than the outcome. They claimed that (according to their data) kicking the ball right down the middle is statistically more likely to result in a goal than kicking to the right or the left. If you’ve ever watched a soccer game, this makes sense, as the keeper almost always jumps left or right preceding the kick, leaving the middle wide open.

Get The Full Seth Klarman Series in PDF

Get the entire 10-part series on Seth Klarman in PDF. Save it to your desktop, read it on your tablet, or email to your colleagues.

trading session
sipa / Pixabay

If this is the case, why don't more players go for the middle? As one of the authors of the paper, Steven Levitt puts it, "If you kick it right down the middle and you don’t score, it is damn embarrassing. So even though the middle is a great play statistically, kickers don’t choose it very often. Some things are even more important than winning, like not looking like a fool."

Another competitive environment apart from the sporting world is that of financial markets. With the successes of passive investing recently, hedge fund performances relative to the market have been publicly scrutinized in the media. Not just hedge funds, but individual investors, pundits, and media outlets' investment picks are frequently publicized for all to see. What is the effect of this? Research has suggested that in the same way the soccer player sublimely factors in the watchful crowd into his decision, investors may be doing the same thing by hedging against embarrassment.

A Lab Experiment

In the 2015 paper, Marco Goulart and a group economic researchers from Brazil conducted a lab study to explore the influence of embarrassment on investment decisions. In the experiment, a large group of undergraduate students participated in a simulated trading session. Participants were either told their performance would be either kept private (contained in an envelope) or made public (exposed on a whiteboard for all to see).

Goulart et al. found investors to make different decisions in this stock market simulation when their performance was made public versus being kept private. The results rely on a concept in behavioral economics known as the disposition effect, where individuals are more prone to sell assets that have gained value relative to its purchase price compared to those that have decreased relative to the same reference point. In the case of Goulart's study, the disposition effect increased significantly in the public condition.

In private, individuals were slightly more prone to realize gains than they were to recognize losses. However, once participants knew they had to write their name and performance on the whiteboard, they realized gains much more frequently than losses. The authors write:

"We speculate that the spike in the realization of gains observed in the public condition of the experiment represents people’s attempt to avoid the embarrassment of finishing the trading session at the bottom of the performance ranking (i.e., among the low performers on the whiteboard). We argue that everything else being equal, our participants are more likely to hold to the goal of avoiding embarrassment than that of achieving pride."

It is perhaps less speculative to assume an egotistic culture on Wall Street. If embarrassment aversion does play a significant role in investor behavior, the implications loom large.