Volume 2, Number 1, 2001 Abstracts
© Copyright Erlbaum 2001


The Effects of Subject Pool and Design Experience on Rationality in Experimental Asset Markets

Lucy F. Ackert
Bryan K. Church

Empirical evidence suggests that prices do not always reflect fundamental values and individual behavior is often inconsistent with rational expectations theory. We report the results of fourteen experimental asset markets designed to examine whether the in-teractive effect of subject pool and design experience (i.e., previous experience in a market under identical conditions) tempers price bubbles and improves forecasting ability. Our main findings are: 1) price run-ups are modest and dissipate quickly when traders are knowledgeable about financial markets and have participated in a previous market under identical conditions; 2) price bubbles moderate quickly when only a subset of traders are knowledgeable and experienced; 3) the heterogeneity of expectations about price changes is smaller in markets with knowledgeable and experienced traders, even if such traders only represent a subset of the market; and 4) individual forecasts of prices are not consistent with the predictions of the rational expectations model in any market, although absolute forecast errors are smaller for subjects who are knowledgeable of financial markets and for those subjects who have participated in a previous market. In sum, our findings suggest that markets populated by at least a subset of knowledgeable and experienced traders behave rationally, even though average individual behavior can be characterized as irrational.

The Influence of Gender on the Perception and Response to Investment Risk: The Case of Professional Investors
Robert A. Olsen
Constance M. Cox

In a previous issue of this journal, O'Barr and Conley, noted that cultural differences caused public pension fund managers to invest differently and more conservatively than their private fund counterparts. An additional insight to is that cultural factors have a non-trivial affect on how assets are managed. This article continues with this theme and suggests that, even with equivalent training, experience and information, investment managers make different decisions based on identifiable cultural differences. This study focuses on professional men and women investment managers who perceive and respond to risk differently. This supports O'Barr and Conley, suggesting cultural factors may be responsible for this risk related gender effect. There is extensive evidence that when faced with social and technological hazards, women are more risk averse than men. This appears to be so even when decision-makers of both genders have the same level of expertise and experience. In the investment realm, non-professional women investors also appear to accept less risk than their male counterparts, after controlling for factors such as age, education, wealth and experience. Although the precise reason for this gender difference in risk taking is un-known, it appears to be related to evolutionary and social factors. This paper is unique in that it investigates the risk/gender difference for professionally trained investors. It is found that women investors weight risk attributes, such as possibility of loss and ambiguity, more heavily than their male colleagues. In addition, women tend to emphasize risk reduction more than men in portfolio construction. While gender differences appear to influence perceptions of risk and recommendations to clients, these differences tend to be the most significant for assets and portfolios at risk extremes.

The Psychology of Financial Decision-Making: Applications to Trading, Dealing, and Investment Analysis
Denis J. Hilton

This paper offers a whole range of areas in which the latest work on psychology, social psychology and behavioral finance could offer competitive advantage both to financial markets as well as individual firms. The aim is to identify potential applications of experimental and organizational psychology to improve the efficiency of financial institutions. The focus is on two major areas of application: trading and dealing in currencies, and investment decision-making. The paper reviews the seven deadly sins in individual decision-making showing how the financial decision-maker may fall prey to them. It also suggests how this knowledge can be put to use in improving efficiency in financial strategy, marketing, and human resource management (selection, training, decision-aiding, and control). The paper concludes by identifying important questions for the financial markets to consider if they are serious about improving managerial practices.

Book Review by Jason Zweig: The Perception of Risk, Paul Slovic, 2000, London: Earthscan Publications.


Volume 2, Number 2, 2001 Abstracts
© Copyright Erlbaum 2001

Training Novice Investors to Become More Expert: The Role of Information Accessing Strategy
Jacob Jacoby
Maureen Morrin
Gita Johar
Zeynep Gürhan
Alfred Küss
David Mazursky

Considerable research has examined how securities information, once accessed, is cognitively processed to arrive at buy, sell or hold decisions. In contrast, this paper ex-amines whether training novice investors to simply apply the information accessing strategies used by better-performing security analysts, prior to actual cognitive processing of the information, would improve their performance. We obtain performance differences by comparing trained subjects who used the recommended strategies with untrained subjects. Notably, these differences emerged even during a significant market downturn during the simulation. Implications of the findings and directions for future research are discussed.

Financial Bubbles: Excess Cash, Momentum, and Incomplete Information
Gunduz Caginalp
David Porter
Vernon Smith

We report on a large number of laboratory market experiments demonstrating that a market bubble can be reduced under the following conditions: 1) a low initial liquidity level, i.e., less total cash than value of total shares, 2) deferred dividends, and 3) a bid—ask book that is open to traders. Conversely, a large bubble arises when the opposite conditions exist.

The first part of the article is comprised of twenty-five experiments with varying levels of total cash endowment per share (liquidity level), payment or deferral of dividends and an open or closed bid—ask book. We find that the liquidity level has a very strong influence on the mean and maximum prices during an experiment (P < 1/10,000). These results suggest that within the framework of the classical bubble experiments (dividends distributed after each period and closed book), each dollar per share of additional cash results in a maximum price that is $1 per share higher. There is also limited statistical support for the theory that deferred dividends (which also lower the cash per share during much of the experiment) and an open book lead to a reduced bubble. The three factors taken together show a striking difference in the median magnitude of the bubble ($7.30 versus $0.22 for the maximum deviation from fundamental value).

Another set of twelve experiments features a single dividend at the end of fifteen trading periods and establishes a 0.8 correlation between price and liquidity during the early periods of the experiments. As a result, calibration of prices and evolution to-ward equilibrium price as a function of liquidity are possible.

Investing in Frankenfirms: Predicting Socially Unacceptable Risks
Baruch Fischhoff
Alain Nadaï
Ilya Fischhoff

When the public decides that a product or production process is socially unacceptable, the share price of the firms involved may suffer. The danger is that, out of distaste, people will refrain from buying the product or the shares. But being able to assess the degree of unacceptability can mean being better able to assess how it will affect a firm's profitability, and being better able to assess the value of a firm. Over the past twenty-five years, many psychological studies have considered predictors of unacceptability for one class of industrial activities: those perceived as producing risks to health, safety, and the environment.

We compare results from several studies of risk perception conducted from 1975—1994 with current consumer boycotts and the screening criteria of socially responsible investment firms–two forms of organized distaste. From both perspectives, high historic ratings on undesirable risk characteristics have predicted current organized aversion. These relationships are discussed in terms of how to make more precise estimates of the direct and indirect effects of social unacceptability on share price. One way is to pay critical attention to the financial disclosures of firms that may have such problems in light of the concurrent state of scientific knowledge. We illustrate these issues with the case of genetically modified organisms.


Volume 2, Number 3, 2001 Abstracts
© Copyright Erlbaum 2001

Unconscious Herding Behavior as the Psychological Basis of Financial Market Trends and Patterns
Robert R. Prechter, Jr.

Human herding behavior results from impulsive mental activity in individuals responding to signals from the behavior of others. Impulsive thought originates in the basal ganglia and limbic system. In emotionally charged situations, the limbic system's impulses are typically faster than rational reflection performed by the neocortex. Experiments with a small number of naïve individuals as well as statistics reflecting the behavior of large groups of financial professionals provide evidence of herding behavior. Herding behavior, while appropriate in some primitive life-threatening situations, is inappropriate and counter-productive to success in financial situations. Unconscious impulses that evolved in order to attain positive values and avoid negative values spur herding behavior, making rational independence extremely difficult to exercise in group settings. A negative feedback loop develops because stress increases impulsive mental activity, and impulsive mental activity in financial situations, by inducing failure, increases stress. The interaction of many minds in a collective setting produces super-organic behavior that is patterned according to the survival-related functions of the primitive portions of the brain. As long as the human mind comprises the triune construction and its functions, patterns of herding behavior will remain immutable.

A Report on the March 2001 Investor Sentiment Survey
David Dreman
Stephen Johnson
Donald MacGregor
Paul Slovic

Steep declines in the value of publicly traded stocks in the first quarter of 2001 left many market observers speculating whether investor sentiment had undergone a significant and negative change, and whether investors would subsequently flee stocks in favor of less volatile investment options. A survey study of investor expectations and confidence was conducted in late March 2001 to capture investor sentiment and compare it with similar measures taken in surveys conducted in 1998 during a period of rapid market incline. The surprising results are that there are only minor differences in investor sentiment in terms of: (a) confidence in the long and intermediate performance of the stock markets; (b) composition of stocks versus bonds in their portfolios; (c) the intention to buy on the dips; (d) the amount of risk investors plan to undertake. The high level of investor confidence observed in 2001 (in spite of a severe drop in market value) is potentially accounted for by psychological processes that influence investor judgment. These processes include reliance on image-driven affective evaluations of common stocks that contribute to excessive optimism.

A Behavioral Model of Stock Market Investors' Impact on Consumption
Samuel B. Bulmash

This paper offers a theory of investor/consumer behavior in the context of an adaptive relationship. It shows how consumer spending and stock market gains and losses interact in a "gradual diffusion" process. The model offers predictions about likely changes in investor behavior, and the impact on the underlying economy in general and consumption in particular. These predictions are validated empirically. Specifically, the paper finds that investors/consumers gradually smooth their "wealth spending" and accelerate consumption as they become more convinced that their gains are permanent.

This is somewhat reminiscent of the "income smoothing" suggested by Friedman [1957]. We present evidence that the consumption wealth spending peaks at approximately 2.5%—3% of the stock market wealth cumulative gain in the previous twelve- to twenty-four-month period, while concurrent effects are negligible. The results also provide a partial explanation for the long cycle of a strong economy in the 1990s, and point out the danger to the economy from a prolonged stock market decline.

On Ignorance, Intuition, and Investing: A Bear Market Test of the Recognition Heuristic
Michael Boyd

This study replicates recent tests of the recognition heuristic as a device for selecting stock portfolios. The heuristic represents a lower limit to the search for information, since simple name recognition is the least one can know about anything. Gigerenzer and others conducted original experiments in this field at the Max Planck Institute for Psychological Research's Center for Adaptive Behavior and Cognition (the "ABC Research Group"). The ABC Group's tests support the use of the heuristic in a bull market environment. This study, conducted in a down market, reaches a different conclusion: Not only can a high degree of company name recognition lead to disappointing investment results in a bear market, it can also be beat by pure ignorance. Virtually the only finding of the ABC Group's study that we match here is that Americans are not very good at picking American stocks to outperform the market.


Volume 2, Number 4, 2001 Abstracts
© Copyright Erlbaum 2001

Toward an Understanding of the Risky Choice Behavior of Professional Financial Analysts
James E. Hunton
Ruth Ann McEwen
Sudip Bhattacharjee

Several studies have reported inefficiencies and/or biases in analysts'ability to incorporate new information into their earnings forecasts. We propose that an important psychological factor associated with optimistic earnings forecasts is the propensity of analysts to engage in risky choice behavior as described by prospect theory. Furthermore, the motivational incentives faced by analysts may exacerbate risky choice behavior during forecast revision, thereby magnifying overestimates of earnings. Sixty professional financial analysts were asked to issue a first quarter and then an annual EPS forecast of a company. The analysts were randomly assigned to two initial forecast accuracy conditions that indicated their initial forecast earnings was 1) essentially the same as actual earnings, or 2) substantially higher than actual earnings. Analysts were also assigned to one of three motivational incentive conditions indicating the analyst and brokerage firm would 1) have no future contact with the fore-cast firm, 2) begin to follow the forecast firm, or 3) establish an underwriting relationship with the forecast firm. The results indicate that analysts who perceived a loss function due to the inaccuracy of prior earnings forecasts tended to choose riskier prospects in subsequent forecast revisions than analysts who perceived their prior earnings forecasts to be ac-curate. These riskier prospects translate into greater overestimates of earnings. Furthermore, while the average risk attitude of the analysts was optimistic, higher levels of motivational incentives were associated with greater risk-seeking behavior by the analysts who perceive a loss function. It appears that the motivational incentives inherent in brokerage firms can exacerbate the risky choice behavior of financial analysts during forecast revision. These findings support the utility of incorporating both cognitive and motivational factors into the prediction of analyst behavior.

Momentum, Rational Agents and Efficient Markets
John Crombez

Descriptive behavioral models explain the momentum anomaly by assuming that financial agents are irrational. However, investors are not tested to be susceptible to the cognitive failures observed in psychological experiments. We consider an environment where financial agents are rational, markets are efficient as defined by the Grossman—Stiglitz [1980] efficiency, and there are market imperfections in the information market. Based on a simulation experiment, we find that returns on momentum strategies can exist in this environment because of the noise in expert information. We empirically find that even in a sample of large and liquid stocks, this noise is still ob-servable and, hence, momentum can be empirically found for these samples even when agents are rational and markets are efficient.

Visibility, Institutional Preferences and Agency Considerations
Lucy F. Ackert
George Athanassakos

We show that market frictions and agency considerations are important concerns when institutional investors make portfolio allocation decisions. For a sample of widely followed firms, institutional holdings increase with increases in visibility as measured by the number of analysts following the firm. We also report a significant seasonal pattern in institutional holdings consistent with the gamesmanship hypothesis, which asserts that institutions rebalance their portfolios in response to agency considerations. Finally, we find that excess returns are highly seasonal with performance, deteriorating when the following by financial analysts increases. "Followed" firms actually exhibit inferior market performance over the 1981—1996 sample period.

Are Malaysian Investors Rational?
Ming-Ming Lai
K. L. T. Low
Ming-Ling Lai

This paper examines the investment practices of Malaysian institutional investors during the bullish and bearish periods. The factors and forces that drive the Malaysian stock market are also identified. The investors used a lot of information within and outside the firm before making any stock selection. The analysis of fundamentals appears to be the most popular method for share appraisal. The survey findings demonstrated that Malaysian investors appeared to be rational and prudent in making financial decisions.

An Experimental Study of the Disposition Effect: Evidence From Macau
Peter M. W. Chui

The disposition effect–the tendency to sell winning transactions too soon and hold losing transactions too long–is examined experimentally in Macau. The findings show that the disposition effect exists strongly under the modified version of the experiment designed by Weber and Camerer [1998]. This study also points out that a psychological factor, the locus of control, can partly explain the disposition effect observed in this experiment.