Volume 1, Number 1, 2000 Abstracts
© Copyright Erlbaum 2000
Thought Contagions in the Stock Market
Aaron
Lynch
The
evolutionary epidemiology of ideas, or thought contagion theory, is introduced
and applied to possible examples in the stock market. It is suggested that
differences in transmissivity, receptivity, and
longevity of belief may contribute numerous irrational influences on the stock
market, generating sources of inefficiency. These include a wide variety of
mechanisms that may generate both positive and negative market overreactions.
The soaring prices of Internet stocks during 1998-1999 are used as an example
of how investment ideas correlating with new communication behaviors may affect
share prices, and how contagion effects in general can affect the broader
market. New avenues of empirical investigation are proposed to test the types
of hypotheses presented.
Overreactions, Momentum, Liquidity, and Price Bubbles in
Laboratory and Field Stock Markets
Gunduz Caginalp
David Porter
Laboratory
asset markets provide an experimental setting in which to observe investor
behavior. Over more than a decade, numerous studies have found that
participants in laboratory experiments frequently drive asset prices far above
fundamental value, after which the prices crash. This bubble-and-crash behavior
is robust to variations in a number of variables, including liquidity (the
amount of cash available relative to the value of the assets being traded),
short-selling, certainty or uncertainty of dividend payments, brokerage fees,
capital gains taxes, buying on margin, and others. This paper attempts to model
the behavior of asset prices in experimental settings by proposing a
"momentum model" of asset price changes. The model assumes that
investors follow a combination of two factors when setting prices: fundamental
value, and the recent price trend. The predictions of the model, while still
far from perfect, are superior to those of a rational expectations model, in
which traders consider only fundamental value. In particular, the momentum
model predicts that higher levels of liquidity lead to larger price bubbles, a
result that is confirmed in the experiments. The similarity between laboratory
results and data from field (real-world) markets suggests that the momentum
model may be applicable there as well.
Measuring Bubble Expectations and Investor Confidence
Robert
J. Shiller
This
paper presents evidence on two types of investor attitudes that change in
important ways through time, with important consequences for speculative
markets. The paper explores changes in bubble expectations and investor confidence
among institutional investors in the
Based on the results of the questionnaires administered during the period, the author develops specific time-series indicators for each of the following: a speculative bubble (an unstable situation with expectations for a increase in the short term only), a negative speculative bubble (an unstable situation with expectations for a downturn in the short term only), and investor confidence (a feeling that nothing can go wrong).
Using the indicators, the author produces indexes indicating the average percentage of the population at a given time with bubble expectations, negative bubble expectations, and investor confidence, respectively.
Investor Overreaction: Evidence That Its Basis Is Psychological
David
N. Dreman
Eric A. Lufkin
Probably
no subject in recent financial literature has generated more controversy than
whether investors behave rationally in pricing stocks, or whether they
overreact to market information, resulting in prices being too high or too low.
Although the efficient market hypothesis states that, with minor exceptions,
securities are rationally priced, repeated evidence has been presented of
predictable over- and underreactions. This evidence
is based primarily on consistently higher returns for out-of-favor stocks and
below-average returns for favored issues. The existence of overreaction in the
marketplace, if it can be proven, is important to both investment
decision-making and theory, and in more acute cases can be the major cause of
financial bubbles and panics.
We present evidence of overreaction by showing that important fundamentals upon which securities prices depend demonstrate little movement in the face of major changes to the returns of favored and unfavored stocks. We can find no explanation other than psychological influences to account for this finding. The paper also provides evidence that over- and underreaction may be a part of the same process.
A Cat Bond Premium Puzzle?
Vivek J. Bantwal
Howard C. Kunreuther
Catastrophe
bonds, the payouts of which are tied to the occurrence of natural disasters,
offer insurers and corporate entities the ability to hedge events that could
otherwise impair their operations to the point of insolvency. At the same time,
cat bonds offer investors a unique opportunity to enhance their portfolios with
an asset that provides a high-yielding return that is uncorrelated with the
market. Despite the attractive nature of these investments, spreads in this
market remain considerably higher than the spreads for comparable
speculative-grade debt. This article uses behavioral economics to explain the
reluctance of investment managers to invest in these products. Finally, we use
simulations to illustrate the attractiveness of cat bonds under a wide range of
outcomes, including the possible effects of model uncertainty on investor
appetite for these securities.
When Cultures Collide: Social Security and the Market
William
M. O'Barr
John M. Conley
In his 1999
State of the Union address, President Clinton raised the possibility of
investing social security funds in the equities market. In this article, two
anthropologists who have studied the culture of the financial world assess the
President's proposal. The analysis focuses on the vast cultural gap between the
private-sector participants in the equities market and the federal bureaucrats
who would inevitably manage social security investments. The authors examine
similar arrangements at the state level, the cultural differences among the
entities involved, and how those differences interfere with fiduciary
decision-making. They conclude that the gap is simply too wide for the proposal
to be workable, and as a result, the adverse consequences likely outweigh the
potential benefits. Although some consequences are foreseeable, more
threatening consequences can be envisioned only in the most general terms.
Volume 1, Number 2, 2000 Abstracts
© Copyright Erlbaum 2000
Thought Contagions in the Stock Market
Aaron
Lynch
The
evolutionary epidemiology of ideas, or thought contagion theory, is introduced
and applied to possible examples in the stock market. It is suggested that
differences in transmissivity, receptivity, and
longevity of belief may contribute numerous irrational influences on the stock
market, generating sources of inefficiency. These include a wide variety of
mechanisms that may generate both positive and negative market overreactions.
The soaring prices of Internet stocks during 1998-1999 are used as an example
of how investment ideas correlating with new communication behaviors may affect
share prices, and how contagion effects in general can affect the broader
market. New avenues of empirical investigation are proposed to test the types
of hypotheses presented.
Imagery, Affect, and Financial Judgment
Donald G. MacGregor
Paul Slovic
David Dreman
Michael Berry
Traditional theories of finance posit that the pricing of securities in
financial markets should be done according to the quality of their underlying
technical fundamentals. However, research on financial markets has tended to
indicate that factors other than technical fundamentals are often used by
market participants to gauge the value of securities. This phenomenon may be
quite prevalent in markets for initial public offerings (IPOs), where
securities lack a financial history. The imagery and affect associated with
securities can be a powerful basis upon which to judge their worth. Advanced
business students in a securities analysis course were asked to evaluate a
number of industry groups represented on the New York Stock Exchange in terms
of a set of judgmental variables. After providing imagery and affective
evaluations for each industry group, the participants judged the likelihood
that they would invest in companies associated with each industry. Imagery and
affective ratings were highly correlated with one another and with the
likelihood of investing. Judgments of performance correlated poorly to
moderately with actual market performance as measured by weighted average
returns for the industry groups studied. The results suggest that imagery and
affect are part of a coherent psychological framework for evaluating classes of
securities, but that framework may have low validity for predicting
performance.
Catastrophic Risk and Securities Design
David Rode
Baruch Fischhoff
Paul Fischbeck
The anomalies, inefficiencies and difficulties in the market for
catastrophic bonds are so pronounced as to lead strongly to the inference that
psychological factors have a major impact on the pricing of these bonds, and on
the lack of acceptance they have en-countered from investors. In this article,
we examine major factors influencing the market for catastrophe bonds. Most of
the economic factors involved and considered either singly or in combination
are insufficient to account for the magnitude of the anomalies observed.
Decades ago, irregularities in the orbit of the planet Uranus allowed
astronomers to deduce the existence of another planet, subsequently named
Pluto. Since the economic forces at work in the marketplace cannot
satisfactorily explain the situation in the catastrophe-bond marketplace, we
infer that the gravitational pull of psychological forces is at work. We
discuss eight psychological dynamics that may influence the pricing,
mispricing, acceptance or lack of acceptance of catastrophe bonds.
Losses from catastrophic events represent an increasing problem for the property and casualty insurance industry. These losses have significant repercussions not only for insurance firms, but also for governmental policy makers and consumers in the insurance market. In principle, one way to deal with these risks is through securitizing them. Doing so would allow spreading risks of local disasters across global capital markets. However, previous attempts at securitizing insurance risks have, by most accounts, met with minimal success. This paper examines possible barriers to securitization, focusing on behavioral responses to such novel instruments. These barriers include the difficulties of conveying the associated risks, even to investors who are sophisticated about finance. Our analyses will draw on research in behavioral decision making and psychology. They will lead to proposals for empirical research and general strategies for making securities design more consonant with investor behavior.
Risk Behavior of East and West Germans in Handling Personal
Finances
Peter Tigges
Axel Riegert
Lothar Jonitz
Johannes Brengelmann
Rolf R. Engel
When "Homo Economicus" stands for
rationality of financial decision-making, then this is clearly an ideal state
not found in real life. Instead, everyday financial decisions are made by using
a number of risk-oriented behaviors, both positive and negative. We investigate
the relationships between such personality traits and financial decisions
following the theory of Brengelmann. We compare
financial risk behavior between East and West German citizens using two kinds
of samples. One type of sample is drawn from the general East and West German
populations. The other is drawn from the readers of the leading business
magazine in East and
Beyond Behavioral Finance
Elton G. McGoun
Tatjana Skubic
Throughout its history, finance theory has made certain simplifying
assumptions regarding human behavior and concerned itself with whether the
implications of these assumptions were true and not with whether the
assumptions themselves were. Recently, however, more interest has been shown in
experimental investigation of these assumptions, and the resultant behavioral
finance has been presented as a significant departure from the current research
paradigm. Recent research in cognitive science, however, is finding that the
mind can and does work differently than traditional finance assumes, and the
differences between the behavioral assumptions of traditional finance and the
supposedly more realistic ones of today-s behavioral finance are frequently
superficial. Knowledge and knowing are likely to be profoundly different from
the forms in which we have incorporated them in our extant models, both
traditional and behavioral, and they differ in ways similar to those which, for
example, have differentiated corporations from corporate images in marketing.
To truly understand what is going on we must go beyond behavioral finance to
address these differences.
Thought Contagion and Financial Economics: The Dividend Puzzle
as a Case Study
George M. Frankfurter
Elton G. McGoun
In this paper we explore the connection between the theory of thought
contagion and the ways of thinking in financial economics. We argue that
financial economics became what it is today not by coincidence, or a
methodically optimal process in search of some universal truth that is
"out there," but by an organized campaign to inhibit thinking. We
show that much of financial economic thinking is influenced by the modes in
which this thought control takes place. We use the dividend puzzle, one of the
great enigmas of modern finance, as a case study to demonstrate the validity of
our thesis.
Volume 1, Number 3, 2000 Abstracts
© Copyright Erlbaum 2000
EDITORIAL COMMENTARY
The Old Psychology Behind "New Metrics" Cash Flow Is
King? Cognitive Errors by Investors
Todd Houge
Tim Loughran
When investors fixate on current earnings, they commit a cognitive error
and fail to fully value the information contained in accruals and cash flows.
Extending the accrual anomaly documented by Sloan [1996], we identify
significant excess returns from a cash flow-based trading strategy. The market
consistently underestimates the transitory nature of accruals and the long-term
persistence of cash flows. We find that the accrual anomaly derives from the
poor performance of high accrual firms, which are more likely to manage
earnings. Combining the accrual and cash flow information also reveals that
investors misvalue the quality of earnings. Contrary
to Fama [1998], these anomalies are robust to the
three-factor model with equally or value-weighted portfolio returns.
Home Bias in International Stock Return Expectations
Michael Kilka
Martin Weber
Despite the advantages of international portfolio diversification, actual
equity portfolio holdings reveal a strong bias towards domestic stocks. One hypothesis
is that this bias can be explained by stock return expectations expressed in
probability judgments. To test that hypothesis and to analyze the underlying
effects that might cause distortions in investors’ expectations, we conducted a
cross country study in
The New Economy Creed: A Case of Thought Contagion
G. Glenn Baigent
William Acar
This paper looks at recent market-related events and the contention,
gradually gaining credence in business circles, that we have entered an age of
a New Economy. According to the New Economy view, the present upswing in the
stock market will, at least in the
We attempt to take a dispassionate look at the New Economy thesis, so as to
provide an explanation for some of the strange phenomena associated with this
decade’s fixation on the stock market and financial rationality. We analyse the paradox of the belief in a one-way swing of the
economic pendulum in terms of market fundamentals as well as investor
sentiment, or potential irrationality. Our analysis confirms the early insights
of Keynes and more recent views of Black. We conclude by formulating a few
caveats for the true believers of this emerging "New Economy creed"
as well as for its cynical detractors.
Market Efficiency or Behavioral Finance: The
Nature of the Debate
George M. Frankfurter
Elton G. McGoun
Academic finance (also known as financial economics) espouses a methodology
that has been largely discredited (or, at the very least, challenged) in all
other disciplines, not to mention the philosophy of science itself. And this
methodology is so ingrained that it is rarely even addressed, let alone
seriously debated. The term behavioral finance, which ought to be applied to a
different, more experimental methodological approach to finance, is instead
applied to a set of papers that make slightly different assumptions in their
mathematics/statistics without even using different methods.
Risk Aversion and the Investment Horizon: A New Perspective on
the Time Diversification Debate
Sanjiv Jaggia
Satish Thosar
Investment managers generally subscribe to the principle of time
diversification. This implies that a larger portion of the portfolio should be
devoted to risky assets as the investment horizon increases. In contrast,
academics have shown that for investors with utility functions characterized by
constant relative risk aversion, the optimal asset-allocation strategy is
independent of the investment horizon. The relative risk aversion in these
studies is assumed to be constant both with respect to wealth as well as
investment horizon. We suggest a utility function that explicitly captures the
notion that individuals are more risk tolerant when the investment horizon is
long, thereby validating the intuitively appealing time diversification argument.