Volume
4, Number 1, 2004 Abstracts
©
Copyright Erlbaum 2003
The Foundations of
Experimental Economics and Applications to Behavioral Finance: The
Contributions of Nobel Laureate
Gunduz Caginalp-University of
Stock Market
Bubbles in the
Trading at prices above the fundamental value of an asset, i.e. a bubble, has been verified and replicated in laboratory asset markets for the past seven years. To date, only common group experience provides minimal conditions for common investor sentiment and trading at fundamental value. Rational expectations models do not predict the bubble and crash phenomena found in these experimental markets; such models yield only equilibrium predictions and do not articulate a dynamic process that converges to fundamental value with experience. The dynamic models proposed by Caginalp et al. do an excellent job of predicting price patterns after calibration with a previous experimental bubble, given the initial conditions for a new bubble and its controlled fundamental value. Several extensions of this basic laboratory asset market have recently been undertaken which allow for margin buying, short selling, futures contracting, limit price change rules and a host of other changes that could effect price formation in these assets markets. This paper reviews the results of 72 laboratory asset market experiments which include experimental treatments for dampening bubbles that are suggested by rational expectations theory or popular policy prescriptions.
Market Underreaction to Large Stock Price Declines: The Case of
This paper examines a sample of ADR stocks that experienced significant stock price declines of more than -15% during a specific month, and finds no evidence of a reversal pattern over the long run. The results are consistent with the predictions of the underreaction hypothesis and the existence of a "momentum" effect in stock prices. The underreaction hypothesis is also supported when ADRs are examined across industries, and for a sample of emerging market ADRs.
Preference for
Risk in Investing as a Function of Trait Optimism and
David M. Sanbonmatsu-University
of
This research examines the role of gender and optimism on the riskiness of investment choices of students (N = 66) in a semester long investment contest with both monetary and academic incentives. Data suggest that males make more risky investment choices than females, and that this difference was primarily due to the riskier choices of optimistic males. In addition, males demonstrated greater variability in final portfolio value than did females. Our results suggest that 1) the well documented gender difference in investment strategies of men and women may be due to a specific subgroup of males (i.e., optimists); 2) that optimism may lead to different behavioral tendencies in men and women depending on the domain; and 3) that the benefits of optimism may be restricted to domains in which continued effort and information seeking are likely to lead to desired outcomes.
Economic Data,
Conventions, and Replication in
Data extracted from naturally occurring markets and other economic environments often suffer from problems like data confounds and intercorrelations. We report results from a series of experimental markets that suggest some of the data problems can be overcome by using experimental techniques. We use predetermined (videotaped) draws to replicate results from prior research. This is contrary to the conventional wisdom in the literature, which holds that draws should be "live." Our results suggest that the price and allocation behavior of markets can be replicated using predetermined draws to initiate trading. Furthermore, the primary strength of the experimental method-control-is maintained.
Research Elsewhere
Robert A. Olsen-Decision Research
Book Reviews
Robert A. Olsen-Decision Research
Volume
4, Number 2, 2004 Abstracts
©
Copyright Erlbaum 2003
The Contributions
of Daniel Kahneman and
Does Analyst
Optimism About Future Earnings Distort Stock Prices?
Stephen Ciccone-University
of
Monthly returns to firms with optimistic expectations are 1.5% lower versus firms with pessimistic expectations, while annual buy-and-hold returns to firms with optimistic expectations are 20% lower. The optimistic component of stock prices lingers months after the optimism is revealed to the market. It also exists separately from the component related to analyst forecast dispersion. The possibility that forecast dispersion is related to transitory versus permanent earnings is proposed.
Anchoring and
Psychological Barriers in Foreign Exchange Markets
Frank Westerhoff-University
of Osnabrueck
This paper develops a simple behavioral exchange rate model in which investor perception of the fundamental value is anchored to the nearest round number. Traders adjust their anchors in two ways. Some believe that exchange rates move toward (perceived) fundamentals, while others bet on a continuation of the current exchange rate trend. The behavior of the traders causes complex dynamics. Since the exchange rate tends to circle around its perceived fundamental value, the foreign exchange market is persistently misaligned. Central authorities have the opportunity to reduce such distortions by pushing the exchange rate to less biased anchors, but to achieve this, they have to break psychological barriers between anchors.
A Behavioral
Decision-Making Modeling Approach Toward Hedging Services
Joost M. E. Pennings-University
of Illinois at Urbana-Champaign and Wageningen
University, The Netherlands
Math J. J. M. Candel-Maastricht
University
Thorsten M. Egelkraut-University
of Illinois at Urbana-Champaign
This paper takes a behavioral approach toward the market for hedging services. A behavioral decision-making model is developed that provides insight into how and why owner-managers decide the way they do regarding hedging services. Insight into those choice processes reveals information needed by financial institutions to improve the design of their financial products. The key elements of the model are related to the characteristics of the owner-managers, thereby exploring the decision units' evaluations of the hedging services provided by futures exchanges. Using structural equation models and data from 467 owner-managers, obtained by means of computer- assisted personal interviews, we find that the elements "exercising entrepreneurial freedom," "perceived performance," and the "owner-manager's reference price" determine their attitude toward using futures. These elements are related to innovativeness, risk attitude, and level of understanding of futures markets.
Portfolio
Composition Choice: A Behavioral Approach
Uri Benzion-The
Technion-Israel Institute of Technology and
Ben-Gurion University
Joseph Yagil-Haifa
University and Columbia University
This experimental study investigates portfolio composition choice for different types of financial assets and different levels of wealth. For a group of financially sophisticated executive MBA students with work experience in capital markets, the findings of this study indicate that the proportion of wealth invested in risky assets increases with wealth for all portfolio compositions examined, and increases with the degree of asset risk. This proportion is found to be as much as three times higher for common stocks than for options: For stock portfolios, it increases from 33% to 44% over the five wealth levels examined, and for options it increases from 11% to 17%. These results may imply a decreasing rel w proportions of their wealth in risky assets possess the following characteristics: they do not invest in options in real life; they sometimes buy lottery tickets; they assign a higher risk level to options than to common stocks; they are female; and they are employed.
The Effects of
Attraction on
The attraction effect occurs when an inferior item changes a decision-maker's perception of the relationship between other available alternatives, contrary to the expectations of rational decision-making. This study presents the first evidence that this effect, which has appeared persistently in consumer research, can influence investment decisions. The study also finds two distinct patterns of reaction to the inferior item as a sign of "cluster attraction"-a way of spreading investment risk. Evidence of attraction means that the values of important facets of corporate reporting may not be stable across an investor's decisions, but may depend on the items presently available for investment. Results of an experiment conducted with approximately 100 graduate students with investing experience or interest show that the investor's perceived values of reported financial or non-financial performance, quality of earnings, and information source reliability are subject to trade-offs and can be altered by the composition of the decision set, rather than by any intrinsic change in the investment candidate itself. The discussion highlights the implications of these findings for an understanding of how investors regard the qualities of financial reporting.
Richard L. Peterson-University of
Volume
4, Number 3, 2004 Abstracts
©
Copyright Erlbaum 2003
Categorical
Thinking in Stock Portfolio Management: A Puzzle?
Isabelle Bajeux-Besnainou-The
Kurtay Ogunc-Watson Wyatt
Worldwide
"What Goes Up
Must Come Down"-How Charts Influence Decisions to Buy and Sell Stocks
Thomas Mussweiler-University
of
Karl Schneller-University
of
Five experiments examine how charts depicting past stock prices influence investing decisions. We expected investors to use extreme past prices depicted in charts as comparison standards to which expectations about future prices are assimilated. Investors should thus expect stocks depicted in a chart with a salient high to perform better than stocks depicted in a chart with a salient low. And as a consequence, investors should be more likely to buy and less likely to sell stocks depicted in a chart with a salient high than a low. Results of five experiments support this reasoning. Whether investors are private or professional and whether background information about the stock was limited or abundant, expectations about future prices assimilated to extreme past prices. Consequently, investors buy more and sell less when the critical chart is characterized by a salient high than a low. The implications of these findings for the core role comparison processes play in investing decisions are discussed.
Profit Warnings
and the Pricing Behavior of ADRs
Dave Jackson-University of Texas-Pan American_Jeff Madura-
We assess the pricing
behavior of American Depositary Receipts (ADRs) in
response to information about their profitability. Specifically, we test for
leakage effects and lagged effects, and we assess the cross-sectional variation
in market inefficiencies related to profit warnings by foreign firms listed on
On Characteristics
Momentum
Hsiu-lang Chen-Department of Finance,
This article investigates whether investors can benefit from information about equity style evolution. The study shows that portfolios formed by firm characteristics such as size, book-to-market, and/or dividend yield can be used to determine investment style dominance. Characteristics momentum, buying stocks with persistent in-favor characteristics and selling stocks with persistent out-of-favor characteristics, conveys valuable information about future stock returns. It is distinct and has longer-lasting effects than price or industry momentum in predicting future returns. In explaining the existence of characteristics momentum profits, this study highlights the importance of slow evolution of changes in firm characteristics. The lifecycle of investment styles can thus have predictive power for trend-chasing investors, who can potentially push up the price of stocks with an in-favor style, and depress the price of stocks with an out-of-favor style.
Short-Term
Overreaction in the
Isaac Otchere-Department
of Finance, The University of Melbourne and University of New Brunswick
Jonathan Chan-Department of Finance,
The University of Melbourne
In this paper, we examine
the short-run overreaction phenomenon in the
Financial
Analysts, Firm Quality, and
We suggest that financial analysts have an incentive to follow the stocks of socially responsible companies, because such stocks meet the growing demands and psychology of the investment community, who want to combine the usual investment goals with social responsibility. Socially responsible investors prefer to hold stocks of companies they perceive as socially responsible or of high quality. Financial analysts then help brokers' marketing efforts by supplying investors with more analysis for stocks of socially responsible or high-quality companies. Using scores from Fortune surveys on perceptions of community and environmental responsibility as a measure of social responsibility and Fortune survey measures of quality as a measure of company quality, we find evidence that stocks of socially responsible and high-quality companies are indeed followed by more financial analysts. The positive relationship among social responsibility, company quality, and analyst following remains significant even after controlling for the effects on analyst following of firm size, share price, the volatility of stock returns, and market-to-book value of equity.
Volume
4, Number 4, 2004 Abstracts
©
Copyright Erlbaum 2003
Bubble Jr.
David Dreman-Dreman Value Management
Riding the Wave of
Sentiment: An Analysis of Return Consistency as a Predictor of
This article analyzes the degree to which return consistency in the past predicts future returns. I show that consistency is a strong predictive measure for future stock returns. In a portfolio context, positively consistent stocks exhibit positive future risk-adjusted returns, and negatively consistent stocks exhibit negative future risk-adjusted returns. The results are economically and statistically significant over multiple subperiods. Also, odd return behavior persists for nearly two years after portfolio formation. Stocks that have been consistently positive (negative) for longer time horizons have higher (lower) risk-adjusted returns during the followingmonththan those thathavebeenconsistent for shorter time periods. Finally, high consistency enhances momentum when the two factors are allowed to interact. Thus, there appears to be strong path dependence in the momentum effect, and consistency in stock returns appears to be an important component of return predictability.
Investor
Confidence and Returns Following Large
I hypothesize that post-event price behavior following large one-day price shocks is related to pre-event price and firm fundamental characteristics, and that these characteristics proxy for investor confidence. Several behavioral theories suggest how investors form their expectations, and I suggest four investor confidence hypotheses based on these theories. In addition to documenting further evidence of investor overreaction, my findings indicate that investors respond differently to negative price shocks than to positive price shocks. In particular, large price decreases generally drive positive post-event abnormal returns, while large price increases do not drive positive or negative abnormal returns. However, my main finding is that this relationship is altered when pre-event return and firm characteristics are introduced. This suggests that certain pre-event characteristics influence investor confidence, which in turn influences buying and selling decisions and thereby drives post-event returns. However, investor confidence appears to be lessened by a price shock effect.
Derivation of
Asset Price Equations Through Statistical Inference
Gunduz Caginalp-University of
We develop a methodology to extract a quantitative model for behavioral effects in markets from empirical data. A set of 24 asset market experiments are utilized to derive an equation of price and its dependence on momentum, fundamental value, excess bid level and liquidity considerations. A difference equation is derived from a statistical analysis of the data. The methods are quite general and can be utilized in conjunction with other behavioral finance effects that influence price dynamics.
Simple and Complex
Market Inefficiencies: Integrating Efficient Markets, Behavioral Finance, and
Complexity
Edgar Peters-PanAgora
Asset Management
Traditional capital market theory says that markets are efficient because investors are rational. The new school of behavioral finance says the opposite. Rather than solving problems "rationally," individuals tend to make biased decisions using pattern recognition techniques. However, what is rational and irrational may depend upon the type of problem we wish to solve and the method we use to solve it. If the market inefficiency is a simple objective problem, then "cool reason" should prevail. However, if the market is a complex system, then the value of data would be ambiguous making it more rational to use pattern recognition techniques. In this article we will find that rational investors would indeed keep certain types of mispricing from happening. Likewise, human behavior and the market complexity cause mispricing that cannot be arbitraged away. In the end, investors are irrational if they use the wrong method to solve a particular type of problem. By examining method and object we can find when investors are rational, when they are irrational. A non-mathematical model integrating efficient markets, behavioral finance, and complex systems is presented.
Regression to the
Mean: One of the Most Neglected but Important Concepts in the
The meaning of "regression to the mean" is discussed, as well as the consequences of failing to recognize its effect on research. The lack of performance persistence among stocks and mutual funds is explained as evidence of a lack of valid variance in the performance of stocks, resulting in steep regression-to-the-mean effects. The ubiquity of regression to the mean is illustrated by showing that it is an important factor in marriage as well as in mutual funds.