Volume 1

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
Vernon Smith

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 U.S. stock market at six-month intervals for the period 1989 to 1998 and for individual investors at the start and end of this period.

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

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 West Germany. It is assumed that West Germans are more risk-oriented than East Germans and that readers of the business magazine are more risk-oriented than the non-readers. The expectations were confirmed. In the general population, West Germans show higher risk excitement, but also a higher degree of strain than East Germans. East Germans are more likely to strive for property. Beyond that, business magazine readers differ from the average population. They show higher degrees of almost all relevant factors. In this subgroup, East Germans remind one of "Musterschüler" as far as handling finances is concerned: They show greater drive, control, and responsibility in financial matters, but feel less distracted than West Germans. These results may be explained by differences in socialization in the former FRGand GDR, where "capitalistic" and "socialistic" values, respectively, are supposed to have dominated theory and practice over long periods of time.

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.

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 Germany and the U.S. comparing participants’ judgments about an identical set of German and U.S. stocks.

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 U.S., last over the long run. This is an important issue on which hinge many important public and private decisions. Yet only special interest groups investigate it.

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.