Volume 10

Volume 10, Number 1, 2009 Abstracts
© Copyright Taylor & Francis, LLC. 2009

Investing in the Unknown and the Unknowable—Behavioral Finance in Frontier Markets
Lawrence S. Speidell - Frontier Market Asset Management

While human nature may be a constant, investors have broadened their horizons, investing in emerging markets and, most recently, the frontier markets (those markets not in the popular emerging market indexes). As they have done so, investors have run head on into cultural differences, behavioral differences, and biases that present challenges from many perspectives. Behavioral finance has explored many aspects of investors' behavior, and we can apply this groundwork to understanding frontier markets from the perspective of foreign, professional and local investors. Across countries, there are significant differences in behavior based on the familiarity bias, trust, loss aversion, and risk preference. Considering these behavioral elements can lead to some insights that investors should keep in mind when investing in frontier markets.

The Hedonic Editing Hypothesis: Evidence from the Finnish Stock Market
Mirjam Lehenkari - University of Oulu, Finland

Prospect theory-based hedonic editing hypothesis posits that people integrate or segregate multiple outcomes so as to achieve the highest perceived value. We test the hypothesis in an actual decision-making context by investigating how stock market investors time their sales of stocks when realizing gains and losses. If the principles that guide investors' behavior are those suggested by the hedonic editing hypothesis, we should observe investors integrating losses more frequently than gains and integrating smaller losses with larger gains rather than the other way around. Our results do not conclusively support either of these assumptions but suggest that the relationship between prospect theoretic preferences and investor behavior is not as general as it might seem.

Behavioral Capital Structure: Is the Neoclassical Paradigm Threatened? Evidence from the Field
Dimitrios Vasiliou - Hellenic Open University
Nikolaos Daskalakis - Athens University of Economics and Business

We show that capital structure decisions and financial behavior in general seems to deviate from the traditional neoclassical paradigm. Behavioral finance and the post Keynesian financial behavior approach provide better explanations in “decoding” financial managers' opinions and behavior. Specifically, our starting point is the analysis of qualitative corporate data from the Greek market. The data come from the answers in a detailed questionnaire, and in this paper we analyze capital structure determination and the relationship between capital structure and stock price. Results are in favor of the market timing approach and the managers' opinions and behavior on issues concerning capital structure determinants, and the relationship between capital structure and stock price seem to be better explained under the behavioral finance proponents and within the post Keynesian paradigm.

Attitudes to Economic Risk Taking, Sensation Seeking and Values of Business Students Specializing in Finance
Lennart Sjoberg - Center for Risk Research, Stockholm School of Economics
Elisabeth Engelberg - Center for Risk Research, Stockholm School of Economics

Financial decision making rarely follows models derived from economic theory, which postulate that people are rational economic actors. Psychological alternatives abound. The Tversky-Kahneman heuristics approach is dominating, but it needs to be complemented with emotional and personality factors, since cognitive limitations do not provide exhaustive explanations of the psychology of decision making. In this paper, attitudes to financial risk taking and gambling are related to sensation seeking, emotional intelligence, the perceived importance of money (money concern), and overarching values in groups of students of financial economics (N = 93). Comparative data were collected for a group of nonstudents. Data on values were also available from a random sample of the population. It was found that the students of finance had a positive attitude to economic risk taking and gambling behavior, a high level of sensation seeking, a low level of money concern, and gave low priority to altruistic values about peace and the environment. The subgroup of participants planning a career in finance showed an even more pronounced interest in gambling.

Behavioral Finance Meets Experimental Macroeconomics: On the Determinants of Currency Trade Decisions
Johannes Kaiser - Laboratory for Experimental Economics, University of Bonn
Sebastian Kube - University of Bonn at Max Planck Institute for Research on Collective Goods, Bonn

A novel approach which conjoins elements of experimental macroeconomics and behavioral finance allows us to study the components of industrial firms' currency trade decisions in the controlled environment of a laboratory. We analyze how firms operate in the currency market in a deterministic two-country model with two currencies. Consistent with presumptions of real-world behavior, subjects in our experiment tend to base their trade decisions on definite rather than on uncertain key data: Interest rates have a high impact, while technical analysis plays a minor role. We finally demonstrate how a simple decision rule that incorporates our findings might outperform the actually observed trade decisions.

Illusion of Control as a Source of Poor Diversification: Experimental Evidence
Gerlinde Fellner - Vienna University of Economics and Business Institute of Economic Policy and Industrial Economics

This paper investigates factors that influence individual portfolio allocations, with particular focus on illusion of control. Participants in the experiment form their portfolios of two risky lotteries and one risk-free alternative with the target to reach a predetermined income. Subjects show illusion of control as they excessively invest in a lottery when they are in charge of the chance move. This finding is amplified when self-selection is possible and mitigated when a well-diversified default portfolio is offered. Presenting sequences of chance moves prior to investment does not affect diversification. In line with excessive extrapolation, the higher the number of observed positive prior outcomes, the more likely is a positive prediction and in turn a higher investment.

Volume 10, Number 2, 2009 Abstracts
© Copyright Taylor & Francis, LLC. 2009

Overconfidence and Active Management: An Empirical Study across Swiss Pension Plans
Christoph Gort - Harcourt Investment Consulting AG

Pension plans in Switzerland favor active management over indexing to implement their strategic asset allocation. Empirical surveys show, however, that their success has been below expectations, as the median performance of Swiss pension plans in domestic and international equities is below market indices even gross of fees. The results of this paper's survey across decisionmakers of Swiss pension plans sheds some light on why active management is still so popular across Swiss pension plans. On average the participants in the sample are prone to the better-than-average-effect. A majority expects their managers and their overall pension plan to outperform the other survey participants in the future. The subjective perceptions of the own skill level relative to the competitors can explain the popularity of active management across Swiss pension plans.

Investors' Decision to Trade Stocks - An Experimental Study
Sharon Shafran - Department of Management and Economics, Open University, Israel
Uri Benzion - Department of Management and Economics, Open University, Israel
Tal Shavit - The School of Business Administration, The College of Management, Israel

This paper experimentally examines the behavior of investors when buying and selling stocks. This behavior was tested under different conditions, among them restrictions on asset holdings or different information conditions. Basic financial theory suggests that subjects buy and sell according to expectations regarding the future prices of assets. On the other hand, behavioral biases, such as the disposition effect, suggest that subjects are affected by past performance of assets. In a series of experiments, subjects were asked to allocate a given endowment among six assets. All the assets had the same normal distribution with positive mean. The results show no disposition effect in the simple case with no restrictions. A reverse disposition effect was found in case 2, where subjects were required to hold only three assets and change one asset on each round. However, when subjects received information on the market return each period, they showed disposition effect when gain and losses are measured relatively to the market. We explain these results by the disappointment effect and momentum trading behavior. The main contribution of the current research is to demonstrate that the disposition effect or momentum behavior can be a product of trading conditions.

Affective Equilibria in the Endowment Effect
Nick Sevdalis - University College London
Nigel Harvey - University College London
Ashley Bell - City University

When people are endowed with an object, they demand more money in order to part with it than they would be willing to pay to acquire it in the first place. This phenomenon is known as the endowment effect. From a behavioral finance point of view, the effect is interesting because the asymmetry between people's willingness to pay to acquire the object versus to part with it seems to be triggered by mere ownership of the object. In this paper, we propose that the endowment effect is due to discrepancies in the affective equilibria between owners and potential buyers of an endowment. We define an affective equilibrium as the price or range of prices for which traders forecast equal post-trade happiness for themselves and for their trading partners. In three studies, we obtain empirical findings that are consistent with this explanation and that also demonstrate erroneous affective forecasting in endowment owners and potential buyers. We discuss these findings in relation to the endowment effect literature. We also suggest that transaction-related emotions should be studied alongside people's risk perceptions to provide a better understanding of financial behaviors.

Testing Intentional Herding in Familiar Stocks: An Experiment in an International Context
Natividad Blasco - Vicerrectorado de Planificacion
Sandra Ferreruela - University of Zaragoza

This paper examines the intentional herd behaviour of market participants within different international markets (Germany, United Kingdom, United States, Mexico, Japan, Spain and France) using a new approach that permits the detection of even moderate herding over the whole range of market return. This approach compares the cross-sectional deviation of returns of each of the selected markets with the cross-sectional deviation of returns of an “artificially created” market free of herding effects. We suggest that intentional herding is likely to be better revealed when we analyse familiar stocks. The results show that only the Spanish market exhibits a significant herding effect.

Impact of Analyst Upgrades and Downgrades of Sectors on Sector Valuations
Aigbe Akhigbe - University of Akron
Jeff Madura - Florida Atlantic University

We apply several theories advanced for the mispricing of individual stock prices to suggest the existence of mispriced sectors. We find that sector upgrades result in a positive and significant sector share price response, while sector downgrades result in a negative and significant sector share price response. The favorable valuation effects associated with sector upgrades are more favorable when there is a high level of trading activity of the stocks in the sector, the sector share price runup is relatively weak, and the prevailing price-to-fundamental ratios in the sector are relatively low. In addition, the negative valuation effects associated with sector downgrades are more favorable when there is a high level of trading activity of the stocks in the sector and the share price runup is relatively strong. Overall, the valuation adjustments in response to changes in sector ratings vary with the prevailing market prices in the sector.

Managing a 401(k) Account: An Experiment on Asset Allocation
James A. Sundali - University of Nevada, Reno
Federico Guerrero - University of Nevada, Reno

This paper reports the results of a behavioral finance experiment on asset allocation. Subjects managed a portfolio and made repeated asset allocations to stocks, bonds, and cash. The task was designed to be similar to what a typical investor would face in managing a 401(k) account for twenty years. The primary manipulation in the experiment was the introduction of portfolio future value projections. The results indicate that subjects who receive future value projections create portfolios with higher allocations to stocks and higher portfolio expected return, and allocations to stocks tends to increase with age. In the aggregate subjects do reasonably well in creating efficient portfolios. The results have implications for reducing myopic loss aversion and for the efficient financial engineering of defined contribution accounts.

Volume 10, Number 3, 2009 Abstracts
© Copyright Taylor & Francis, LLC. 2009

Commentary: A Better Mousetrap: Economics, Psychology, Blind Spots and Reform
John Smythies - Center for Brain and Cognition, U.C.S.D.

This article explores one aspect of the behavioral economics of the current financial crisis, namely, the loss of trust between clients and their financial advisors. The operation of unconscious mechanisms of denial, displacement, and the development of a number of blind spots leading to overt and covert hostility is explored. Means of dealing with the situation are suggested.

Are Equally Likely Outcomes Perceived as Equally Likely?
Moshe Levy - Hebrew University
Golan Benita - Hebrew University

Subjective probability weighting is well known as an important factor in decision making. The case of equally likely outcomes is of special importance for two reasons. First, it is encountered in practice often, when expectations are typically based on a given set of historical observations that are each observed once. Second, many researchers believe that in this case probabilities are not subjectively weighted. If this hypothesis is correct, the case of equally likely outcomes can be employed to make clear inferences about the utility/value function, with a neutralization of probability weighting effects. We experimentally examine whether equally likely outcomes are indeed perceived as equally likely. Surprisingly, we find a clear negative answer. Moderate outcomes are significantly overweighed relative to extreme outcomes. Several important implications for models of decision making and economics are discussed.

Does the Consciousness of the Disposition Effect Increase the Equity Premium?
Patrick Roger - Strasbourg University, EM Strasbourg Business School, LARGE Research Center

The disposition effect is a well-established phenomenon in the empirical and experimental financial literature. It leads to sell winners too early and to hold losers too long. In this paper, we show that the consciousness of the disposition effect by investors lead them to require a greater risk premium to invest in stocks (when compared to rational investors). We also analyze the role of the evaluation period for disposition investors. We show that the risk premium they require is a decreasing function of the delay between two evaluations of their portfolio. The influence of the evaluation period on the equity premium looks like the one induced by myopic loss aversion (Benartzi-Thaler [1995]), but the origin is different. Valuing more often a portfolio gives more occasions to sell winning stocks and then decreases the expected return. This point is analyzed by assuming that returns are driven by a Brownian motion and that investors evaluate their portfolio at regularly spaced dates.

Disposition Effect and Flippers in the Bursa Malaysia
Fennee Chong - University Technology MARA

This paper discusses whether investors' decisions to flip or to hold on to their initial public offerings (IPOs) in the immediate aftermarket are subject to the disposition effect as introduced by Shefrin and Statman [1985]. Using 132 IPOs listed on the Main Board of the Bursa Malaysia, this study found that the disposition effect did indeed exist among IPO investors in the Bursa Malaysia. Investors were found to be 2.64 times more willing to flip winning compared to losing IPOs. Further, after scrutinizing the long run ex-post performance of the winners' and losers' portfolios, it was found that the tendency for investors to flip winning IPOs arising from their “fear of regret” was justifiable. Nonetheless, an investor's decision to hold on to losers was found to be a suboptimal behavior. This was because the ex-post performance of the losers was not significantly better than their initial performance. Finally, this study also uncovered that investors' mean revert anticipation was not justified by the ex-post return.

Dimensionality of Risk Perception: Factors Affecting Consumer Understanding and Evaluation of Financial Risk
Ivo Vlaev - University College London
Nick Chater - University College London
Neil Stewart - University of Warwick

This article describes two studies of the factors affecting consumer understanding of financial risk. The first study investigated factors affecting people's perception and comprehension of information about the risks related to retirement investments. First, we asked respondents to list possible risk factors related to investment in a pension plan. Then we obtained ratings of different factors (e.g., the perceived level of knowledge about an investment) that could affect perception of the risk of financial products and retirement investment decisions. Finally, we asked the subjects to rate 11 different descriptions presenting risk information about the same financial product. The risk information framing that received highest rating presented risk as variation between minimum and maximum values with an average in between. The second study demonstrated the risk framing that received highest ranking also prompted more stable risk preferences over a 3-month testing period in comparison to standard measures of risk aversion. Thus, the second study corroborated the importance of the findings in the first study and also indicated that, although people can exhibit stable risk preferences if we ask them the right questions, these preferences were very specific to the risk domain.

Time Variation in Analyst Optimism: An Investor Sentiment Explanation
Hong Qian - Oakland University

Many studies have documented that analyst forecasts are overly optimistic on average. Using quarterly observations from 1984 to 2002, this article shows that forecasts exhibit optimism for most of the quarters under examination, but the level of optimism varies substantially over time. More important, after correcting the measurement problem caused by price, this article does not find optimism greatly diminished during most of the 1990s. However, consistent with previous findings, the period of 1999 to 2000 displays pessimistic forecasts, especially for large firms and growth firms. The macroeconomic factor does not have significant impact on analyst optimism. In contrast, the time-varying investor sentiments measured by 2 Chicago Board Options Exchange (CBOE) put-call ratios, and the cross-sectional skewness in the forecast errors, play an important role in explaining the time variation in analyst optimism. Finally, analysts track institutional investor sentiment more closely, except for small firms.

Do Investors React Differently to Range and Point Management Earnings Forecasts?
Ning Du - DePaul University

This study investigates the differential effects of range and point management earnings forecasts. I focus on investors' reactions to earnings forecasts with both favorable and unfavorable outcomes under high information uncertainty. Based on theories in judgment and decision making, I predict that investors' reactions to range forecasts depend on the perceived favorability of earnings forecasts. Experimental results are consistent with the prediction. Participants allocate the most resources to firms issuing favorable range forecasts and the least to those with unfavorable range forecasts. Interestingly, range and point forecasts do not have differential effects on participants' earnings predictions, confidence judgments, and risk judgments.

Interplay of Investors' Financial Knowledge and Risk Taking
Alex Wang - University of Connecticut-Stamford

There are many possible explanations for the financial behavior of investors. One of the explanations is financial knowledge. Using a survey data, this study demonstrates that, at least for investors, their objective knowledge, subjective knowledge, and risk taking are highly correlated. More importantly, gender emerges as an important factor that differentiates investors' levels of objective knowledge, subjective knowledge, and risk taking, whereas investors' subjective knowledge mediates investors' objective knowledge on risk taking.

Analysts Get SAD Too: The Effect of Seasonal Affective Disorder on Stock Analysts' Earnings Estimates
Steven D. Dolvin - Butler University
Mark K. Pyles - College of Charleston
Qun Wu - SUNY Oneonta

Previous research finds that stock analysts exhibit both optimistic and pessimistic biases in their earnings forecasts, with the net result being a consistent but declining overestimation of forecasted earnings. We extend this research by examining the potential effect of seasonal affective disorder (SAD), a documented psychological condition that produces heightened pessimism and risk aversion during the fall and winter months, on stock analysts' earnings estimates. Our results suggest that analysts are generally optimistic in their forecasts but significantly less so during SAD months. We also find this relation to be most pronounced for analysts located in northern states, who should be the ones most impacted by the disorder. We conclude that while the effect of SAD appears to be present, it actually seems to overcome an existing positive bent in earnings forecasts, thereby making estimates more accurate. Our findings add to the existing literature by identifying an additional psychological bias that could potentially influence stock analysts' earnings estimates.

Investor Sentiment and Time-Varying Market Risk in Market-Neutral Hedge Funds
Jarkko Peltomäki - University of Vaasa

This paper examines whether market risk in market-neutral hedge funds is associated with investor sentiment. It is expected that market risk of these hedge funds depends on investor sentiment caused by return-chasing behavior of investors. The results provide support for this expectation, and thus the risk in the market neutral hedge fund strategy caters to investors' preferences. The exposure of market-neutral hedge funds to commonly used empirical risk factors is also altered by investor sentiment.

Departures from Rational Expectations and Asset Pricing Anomalies
Andrei Semenov - York University

We investigate the potential of the consumption CAPM with pessimism, doubt, and the availability heuristic in the agent's beliefs to resolve the equity premium and risk-free rate puzzles. Using the nonlinear GMM estimation techniques, we find that doubt and the availability heuristic play an important role in explaining the cross-section of asset returns. However, when taken alone, these deviations from rational expectations cannot resolve the equity premium and risk-free rate puzzles. This result is robust to the assumption that the expected value of an uncertain prospect is nonlinear in the subjective outcome probabilities.