Volume 13

Volume 13, Number 1, 2012 Abstracts
© Copyright Taylor & Francis, LLC. 2012

Estimating the Loss from the Disposition Effect: A Simulation Study
Amit Das - Qatar University

The disposition effect is the tendency of investors to sell winners too early and hold losers too long. We use a simulation model to estimate the loss attributable to the disposition effect using historical data from five different stock markets around the world in four time periods. We find that loss increases with the relative unwillingness to sell losers, and is not reduced by trading more often. We also find that delaying the sale of winning stocks, and applying a selling discipline that sells off stocks once they cross preset thresholds, can reduce the loss attributable to the disposition effect.

Investor Rationality and Financial Decisions
Gil Cohen - The Max Stern Academic College of Emek Yezreel
Andrey Kudryavtsev - University of Haifa

This study used questionnaires completed by MBA finance students to test the degree of investors’ rationality when the latter construct a portfolio or make loan decisions. We found that with respect to stock decisions, irrationality cannot be established. Investment in stocks was found to be influenced by expectations, past experience in the capital market, and knowledge about the past performance of selected market indices. With respect to corporate bonds, we found that, as expected, expectations about interest rate changes influenced the decision to invest in those bonds, as did past experience in the capital markets. The decision to invest in government bonds was the decision least likely to be based on rationality. With respect to loans, we found an expected negative relationship between the willingness to take out loans based on the prime interest rate and expectations about changes in interest rates.

Mental Accounting and False Reference Points in Real Estate Investment Decision Making
Michael J. Seiler - Old Dominion University
Vicky L. Seiler - Johns Hopkins University
Mark A. Lane - Old Dominion University

This study examines a number of behavioral finance issues as they relate to real estate investments. We find a statistically significant degree of mental accounting at all points throughout the disposition effect curve when holding a real estate investment in isolation versus holding the asset as part of a mixed-asset portfolio. We also identify four distinct disposition curve shapes beyond the traditional “S-shaped” curve, where investors are more willing to sell an asset that is in the gains domain. Furthermore, we conclude that an investor's willingness to sell jumps by the greatest amount when going from zero return into profitable territory. Finally, this false reference point does take into consideration transaction costs.

Money Illusion and Nominal Inertia in Experimental Asset Markets
Charles N. Noussair - Tilburg University
Gregers Richter - Swarovski Corporation
Jean-Robert Tyran - University of Vienna and University of Copenhagen

We test whether large but purely nominal shocks affect real asset market prices. We subject a laboratory asset market to an exogenous shock, which either inflates or deflates the nominal fundamental value of the asset while holding the real fundamental value constant. After an inflationary shock, nominal prices adjust upward rapidly, and we observe no real effects. However, after a deflationary shock, nominal prices display considerable inertia and real prices adjust only slowly and incompletely toward the levels that would prevail in the absence of a shock. Thus, an asymmetry is observed in the price response to inflationary and deflationary nominal shocks.

Can Diversification be Learned?
Ann Marie Hibbert - West Virginia University
Edward R. Lawrence - Florida International University
Arun J. Prakash - Florida International University

We investigate the role of financial education in household portfolio allocation decisions using data from a survey of 1,382 professors at universities across the United States. The results suggest that knowledge of diversification increases the likelihood that investors will efficiently allocate their investments across the major asset classes as well as invest in foreign assets. However, we find that investors with advanced knowledge of finance still tend to hold undiversified equity portfolios.

Automated Finance: The Assumptions and Behavioral Aspects of Algorithmic Trading
Andrew Kumiega - Illinois Institute of Technology–Stuart School of Business
Benjamin Edward Van Vliet - Illinois Institute of Technology–Stuart School of Business

Automated trading now dominates the financial markets. Yet no philosophy of academic research into the topic exists. As the growth in automated trading suggests their greater returns and predictability, this paper examines stability and statistical control of trading process outputs as method of justifying predictions of future performance. New assumptions presented can form a foundation for positive research under this revolutionary paradigm, one almost completely ignored in the financial literature. The traditional financial literature rests on the assumption of normality of inputs, while trading systems aspire to the more rigorous engineering standard of justification. The end game is that now behavioral aspects, not of traders but of trading system research and development projects, drive market returns.

Psychological and Social Forces Behind Aggregate Financial Market Behavior
Thomas Fenzl - University of Klagenfurt
Linda Pelzmann - University of Klagenfurt

The cycle of boom and crash is a “natural” element in financial market history, and numerous research works have provided evidence that market prices spend far more time deviating from postulated theoretical equilibrium than actually tending towards it. In particular, nonmean-reverting dynamism in financial markets may be produced by mass psychological dynamics in the patterns of human aggregate behavior, which result from nonrational herding impulses sensed by market participants in complex and uncertain situations. Based on a literature review and the analysis of several case studies, this paper elucidates postulated mechanisms behind, and characteristics of, herding in financial markets. The main goal is to raise awareness of the often little-understood point that collective behavior does not simply sum up preexisting individual motives and preferences. Thus, the paper focuses on the mechanism of how individually unintended aggregate outcomes such as financial market booms and panics are shaped by collective dynamics and social interactions between traders and their social environment.

Behavioral Aspects of Covered Call Writing: An Empirical Investigation
Arvid O. I. Hoffmann - Maastricht University
E. Tobias S. Fischer - Maastricht University

Various explanations for the popularity of covered call option strategies have been explored in the literature. According to Shefrin and Statman [1993], framing and risk aversion can help justify its attractiveness to investors. Applying prospect theory and hedonic framing, these authors predict that in a world of frame dependence an investor that is sufficiently risk averse in the domain of gains will prefer a covered call position over a stock only position and that certain covered call designs will be preferred despite identical cash flows. To date, the relationship among framing, risk aversion, and covered call writing has not been empirically tested. We gather empirical evidence to complete this gap in the literature. We find highly significant empirical evidence for a pronounced framing effect with respect to different covered call designs with equal net cash flows as well as covered calls in general. We find only scarce empirical evidence for a relationship between risk aversion in the domain of gains and a preference for covered calls. In order to observe a positive relationship between risk aversion and covered call writing, investors with above average risk aversion seem to be required.

Volume 13, Number 2, 2012 Abstracts
© Copyright Taylor & Francis, LLC. 2012

How the Shift to Quality Distinguished Winners from Losers During the Financial Crisis
Sean M. Davis - University of North Florida
Jeff Madura - Florida Atlantic University

We examine winner and loser portfolios as a result of the financial crisis from 2007 to 2008 to determine the ex-ante characteristics of winner and loser stocks. The best performing decile actually gained more than 27% in our sample of 2,267 firms while the worst performing decile lost nearly 90% of its value. We show that investor sentiment shifted away from risky stocks, but risk aversion went beyond an avoidance of market and intrinsic risk. Smaller, value stocks with high-leverage significantly underperformed the market while investors shifted to larger, glamour stocks with high dividend yields. Our results provide strong support for the theories of projection bias, risk aversion and regret avoidance.

A New Pseudo-Bayesian Model with Implications for Financial Anomalies and Investors’ Behavior
Kin Lam - Hong Kong Baptist University
Taisheng Liu - Standard Chartered Bank (Hong Kong) Limited
Wing-Keung Wong - Hong Kong Baptist University

Barberis, Shleifer, and Vishny [1998] and others have developed Bayesian models to explain investors’ behavioral biases by using conservative heuristics and representative heuristics in making decisions. To extend their work, Lam, Liu, and Wong [2010] have developed a model of weight assignments using a pseudo-Bayesian approach that reflects investors’ behavioral biases. In this parsimonious model of investor sentiment, weights induced by investors’ conservative and representative heuristics are assigned to observations of the earning shocks of stock prices. Such weight assignments enable us to provide a quantitative link between some market anomalies and investors’ behavioral biases. This paper extends their work further by developing a theory to explain some market anomalies, including short-term underreaction, long-term overreaction, and excess volatility. We also explain in detail the linkage between these market anomalies and investors’ behavioral biases.

Why Do Investors Buy Bad Financial Products? Probability Misestimation and Preferences in Financial Investment Decision
Marc Oliver Rieger - University of Trier

We study the influence of systematic probability misestimation on complex financial investment decisions on the context of structured financial products. Structured products have become more and more complex. We study the question whether this complexity might be a sophisticated method to exploit systematic biases in probability estimation of investors in order to make products look safer and more attractive than they actually are. We present results of an experiment that focused on probability estimates in the context of certain classes of structured products, in particular barrier reverse convertibles, bonus certificates, and worst-of basket certificates. We find that behavioral biases, for example, the conjunction fallacy, increase the subjective attractiveness of these product types. We also investigate potential ways to de-bias investors by providing additional information.

Understanding the Risk Anatomy of Experienced Mutual Fund Investors
Nidhi Walia - Punjabi University , Patiala
Ravi Kiran - Thapar University , Patiala

Risk-return tradeoff comprises the critical rationale for every investment decision, where every investor wishes to assume maximum return at minimum risk. However, investors differ in their decisions to assume investment risk because of their personal constraints. This study examined the factors responsible for creating gaps in investors’ risk perception by focusing on three issues: (a) disclosure practices, (b) investors’ perception about the mutual funds’ services, and (c) risk anatomy. Avoiding the extreme investment avenues, the study has included mutual fund investors only because investment in mutual funds is put forth in a way that assumes calculated risk and assures maximum return. The results highlighted by the study revealed that investors’ demographic base, along with weak disclosure practices of mutual funds and the presence of volatility, shapes the anatomy of investors’ risk decisions. The major implications of the study highlight that investors’ demographic base has a significant impact on their risk perception, and financial services intermediaries should respond differently to the varied needs of individual investors based on their age, knowledge, income, and social responsibilities.

Influencing Financial Behavior: From Changing Minds to Changing Contexts
Paul Dolan - London School of Economics
Antony Elliott - The FairBanking Foundation
Robert Metcalfe - University of Oxford
Ivo Vlaev- Imperial College London

This article reviews interventions that are effective in changing behaviours in ways that enhance financial capability. Traditionally, behavior change has been seen through the lens of “changing minds”: if we can change the way people think—their beliefs, attitudes, and goals—then we can change the way they behave. More recent developments in behavioral theory show that “changing contexts” can have a powerful effect on behavior: we can change behavior by sometimes quite subtle changes to the environment or context within which decisions are made. We focus largely on the influence of context and provide examples from current UK banks that have changed the “choice architecture” of their products.

Investors’ Exposure Rating and Stock Returns
Gil Cohen - The Max Stern Academic College of Emek Yezreel

This study examines whether investments based on herd behavior can outperform the market. It utilizes an investment exposure rating system calculated as the percentage of “clicks” on a specific stock banner on a popular business portal. Comparing the returns of a portfolio that consisted of the ten most “clicked” stocks to the returns of the stocks on the Tel Aviv 100 index (TA100) showed that the clicked portfolio did not outperform the index during the examined period. Moreover, a high exposure rating was negatively correlated with returns and positively correlated with higher risk. These results strengthen the hypothesis that investment based on herd behavior is not a winning strategy.

Earnings Management, Managerial Optimism, and IPO Valuation
Pei-Gi Shu - Fu Jen Catholic University
Sue-Jane Chiang - Fu Jen Catholic University
Hsin-Yu Lin - Fu Jen Catholic University

We postulate that both managerial overoptimism and earnings management using accruals to boost accounting numbers effect on initial public offering (IPO) valuation. Referring to Purnandam and Swaminathan [2004], we gauge the IPO intrinsic values with respect to the offer price and the initial price. The portion that real offer (initial) price is above the intrinsic offer (initial) price is defined as offer premium (overreaction). Using 287 Taiwan's IPOs in sampling period 2004–2008, we find that most IPO firms were overpriced rather than underpriced. The offer premium is neither affected by earnings management nor managerial optimism, which is probably due to the greater scrutiny by the associated underwriters who are less gullible to managerial optimism or earnings management. In contrast, in initial market price valuation investors are cautious to take the face value of earnings management when IPO managers are perceived of moderate optimism. However, investors directly discipline overoptimistic managers with a lower initial valuation. Managerial overoptimism is the dominant factor in explaining long-run underperformance. We find that offer premium is positively associated with overreaction. Moreover, earnings management, albeit unrelated to overoptimism and offer premium, is positively related with initial overreaction and long-run underperformance.

Volume 13, Number 3, 2012 Abstracts
© Copyright Taylor & Francis, LLC. 2012

On David Dreman's Contrarian Investment Strategies: The Psychological Edge
Tim Loughran - University of Notre Dame

Social Learning Among Rational Analysts
Manaswini Bhalla - Indian Institute of Management

This paper empirically investigates learning among financial forecasters. I test for informational cascades or rational herd behavior among financial analysts. I conduct a set of nonparametric tests and show that analysts not only learn but also believe that their predecessors learn from each other. I also test a structural parametric model of social learning among financial analysts. This comes around the problem of common information in influencing similar forecasts among analysts. Here, too, I find no evidence that analysts make independent forecasts.

Impact of Heterogeneous Confidences on Investment Style
Jianguo Xu - Beijing University

I study trading on public information when investor beliefs are heterogeneous in both optimism and confidence. Two sources of heterogeneous confidence, private information and overconfidence, are jointly considered. Heterogeneous confidence can generate trading in the absence of noise trading and private information. The model predicts that more confident traders are contrarians while less confident traders are momentum chasers due to different information sensitivity. Interestingly, the model synthesizes existing evidence on momentum and contrarian trading of inside, individual, institutional, and foreign investors surprisingly well. Testable hypotheses are discussed.

The Impact and Source of Mental Frames in Socially Responsible Investing
Katherina Glac - Opus College of Business

Past research on socially responsible investing has provided insight into the demographic makeup of socially responsible investors, what distinguishes them from non-socially responsible investors, and what are their motives. However, our understanding of the decision process behind socially responsible investing (SRI) is still limited, since only a few studies have tested hypotheses about investor behavior in the context of SRI. This paper reports on two empirical studies that examine the role mental frames play in the decision-making process behind SRI. Study 1 focuses on the impact of mental frames on the percentage of SRI in an investor's portfolio and the interaction between mental frames and investor expectations about corporate social responsibility. Study 2 examines individual and environmental factors that influence the type of mental investment frame individuals hold.

Impact of Biased Pecking Order Preferences on Firm Success in Real Business Cycles
Andreas Mueller - Aachen University of Technology (RWTH)
Malte Brettel - Aachen University of Technology (RWTH)

Studies on behavioral corporate finance have documented that overconfident managers invest more than their more rational peers. Reasons include that overconfidence reduces managers’ ability to perceive risk correctly. However, although it has been addressed in several theoretical models, the impact of overconfidence on firm success has received little empirical examination. Based on a unique 10-year panel dataset of German chief executive officers (CEOs) and their companies, we investigate the relationship between overconfidence and firm success. In line with principal agent theory and the hubris hypothesis, we find negative effects of CEO overconfidence during economic recessions. However, we also find a strong positive impact of CEO overconfidence on firm profitability and stock market performance during the early phases of the business cycle. These novel insights imply that overconfidence operates using different mechanisms in routine than in one-time situations. In particular it hints at heightened individual effort and work performance of overconfident individuals as described in psychological studies. Our findings suggest a reciprocal relationship between macroeconomic developments and microeconomic decision-making, a finding that may help to illuminate aggregated patterns such as herding and investment bubbles and the current economic and financial crisis.

Disposition Effect Among Contrarian and Momentum Investors
Elżbieta Kubińska - Cracow University of Economics
Łukasz Markiewicz - Kozminski University
Tadeusz Tyszka - Kozminski University

We provide evidence of disposition effect propensity for stock trading simulation participants employing a contrarian versus a momentum strategy. We found that even subjects playing with chips rather than real money remain vulnerable to those effects. Both tendencies were generally evident in our sample, but we also found individual differences. Subjects seemed to be contrarians both on position opening and on position closing. The main hypothesis of this paper states that contrarian investors are more prone to the disposition effect than are momentum traders. The model proposed by Dacey and Zielonka [2008] plays a crucial role in formulating this hypothesis. We consider the disposition effect not only in terms of the value function but also of the probability weighting function. In accordance with our hypothesis, we found that contrarian traders are more prone to the disposition effect.

Forward and Falsely Induced Reverse Information Cascades
Michael J. Seiler - Old Dominion University

This study is the first to empirically test both forward and (falsely induced) reverse information cascades in an experimental setting using real-time instant feedback to participants. We find that, on average, individuals abandon their private information sets in favor of the group's as early as three steps and as late as five steps into the information discovery process. These findings are important to the fields of both finance and real estate in that we document a personality trait that causes individuals to be swayed from their independently chosen course of action. The results have ramifications for herding behavior and when modeling the spread of society's willingness to strategically default.

What Determines Investors’ Purchases and Redemptions?
Laura Andreu - University of Zaragoza
Noemí Diez - University of Zaragoza
Cristina Ortiz - University of Zaragoza
José Luis Sarto - University of Zaragoza

This study examines the investment flows of Spanish domestic equity funds. Increasing research is specialized in analyzing the determinants of fund flows, but few studies have been able to investigate buying and selling behavior separately. Unique data from Spain allow us to tackle this issue by using exact information of purchases and redemptions. We find that investment flows are sensitive to past performance, though this sensitivity is more noticeable when using inflows and outflows in contrast to implied flows. Furthermore, our empirical results suggest asymmetric behavior of investors given that purchases are better explained by fund return than redemptions. In general, investors are risk averse and fee-sensitive and do not value greater size of Spanish equity funds.

Framed Field Experiment with Stock Market Professionals
Jukka Ilomäki - University of Tampere

We study the behavior of the stock market professionals in the experimental settings. A novelty of the experimental design is the use of real financial market data and real private information. In this study, we compare two different subject pools: the forecasts of uninformed investors whose only information is past returns and the forecasts of informed investors whose information is reliable private information and past returns. We found that the affect heuristic in forecasts occurs as both informed and uninformed investors use large financial center past returns for forecasting small country stock returns. The results suggest that stock market professionals have behavioral bias, such as the illusion of validity in this experiment.

Importance of Catering Incentives for Growth Dynamics
Denys Glushkov - University of Pennsylvania
Katsiaryna Salavei Bardos - Fairfield University

This paper tests whether the dynamics of firm growth metrics, such as sales and investment growth, are consistent with firms catering to the market by delivering growth when stock prices are more sensitive to growth-related news. After developing growth valuation premium measures, we document four main results consistent with catering theory. First, time periods of high growth premium are followed by higher-than-expected growth indicators. Second, catering to the premium is more pronounced for firms whose managers care more about maximizing short-term stock prices. Third, firms whose managers care more about short-term stock prices have higher time-series volatility of median sales, investment, and PPE growth. Finally, conditional trading strategy based on timing the revenue growth premium yields 26 basis points per month after adjusting for risk and postearnings announcement drift.

Analyst Recommendations, Earnings Forecasts and Corporate Bankruptcy: Recent Evidence
Stewart Jones - University of Sydney
David Johnstone - University of Sydney

This study builds on recent research by Clarke, Ferris, Jayaraman, and Lee [2006]. Based on a sample of U.S. bankruptcies between 1995 and 2001, Clarke et al. failed to find evidence of a positive bias (or overoptimism) in analyst recommendations. We extend Clarke et al.'s findings by including the Global Financial Crisis (GFC) period and using an international sample of large corporate bankruptcies (the combined total assets of our firm failure sample exceed US$1.5 trillion). We also extend their research by examining the explanatory and predictive power of earnings growth forecasts, analyst downgrades/upgrades, and analyst coverage in a firm failure model. Overall, we find significantly more evidence of analyst overoptimism than did Clarke and colleagues.

The Role of Financial Education in the Management of Retirement Savings
Ann Marie Hibbert - West Virginia University
Edward R. Lawrence - Florida International University
Arun J. Prakash - Florida International University

We investigate the role of financial education in the management of Defined Contribution retirement savings plans. We survey Finance and English professors from universities across the United States and compare the management of their savings in the TIAA-CREF® plans. We find that compared with English professors, Finance professors allocate a larger share of their retirement savings to equities, they manage their retirement portfolios more actively, and they are less likely to practice naïve diversification strategies.

Trust: The Underappreciated Investment Risk Attribute
Robert Olsen - Decision Research

Research indicates that perceptions of investment risk are multi attribute and depend heavily on individual goals and experience as well as subjective asset characteristics such as distributions of possible returns. One attribute that has particular significance where the evaluation task is complex and time dependent is Affect. Affect refers to the positive or negative feeling state associated with a particular decision. Trust is one of the most recognized affective states as it is the implicit “backbone” of cooperative behavior. Trust is a “psychological state comprising the intention to accept vulnerability based upon expectations of the intentions and behavior of the trusted party.” It has been noted that there is hardly an economic transaction that does not involve trust to some degree. This brief paper is the first to empirically examine interpersonal trust as an attribute of individual investment risk perceptions and as an influence on aggregate market risk premiums. It also suggests that recent U.S. financial bubbles and crashes were, in part, trust-induced swarm behaviors.

Editorial Board EOV