Volume 4, Number 1, 2004 Abstracts
Copyright Erlbaum 2003

The Foundations of Experimental Economics and Applications to Behavioral Finance: The Contributions of Nobel Laureate Vernon Smith
Gunduz Caginalp-University of Pittsburgh
Kevin McCabe-George Mason University
David Porter-George Mason University

Stock Market Bubbles in the Laboratory
David P. Porter-George Mason University
Vernon L. Smith-George Mason University

Trading at prices above the fundamental value of an asset, i.e. a bubble, has been verified and replicated in laboratory asset markets for the past seven years. To date, only common group experience provides minimal conditions for common investor sentiment and trading at fundamental value. Rational expectations models do not predict the bubble and crash phenomena found in these experimental markets; such models yield only equilibrium predictions and do not articulate a dynamic process that converges to fundamental value with experience. The dynamic models proposed by Caginalp et al. do an excellent job of predicting price patterns after calibration with a previous experimental bubble, given the initial conditions for a new bubble and its controlled fundamental value. Several extensions of this basic laboratory asset market have recently been undertaken which allow for margin buying, short selling, futures contracting, limit price change rules and a host of other changes that could effect price formation in these assets markets. This paper reviews the results of 72 laboratory asset market experiments which include experimental treatments for dampening bubbles that are suggested by rational expectations theory or popular policy prescriptions.

Market Underreaction to Large Stock Price Declines: The Case of ADRs
Georgina Benou-Florida Atlantic University

This paper examines a sample of ADR stocks that experienced significant stock price declines of more than -15% during a specific month, and finds no evidence of a reversal pattern over the long run. The results are consistent with the predictions of the underreaction hypothesis and the existence of a "momentum" effect in stock prices. The underreaction hypothesis is also supported when ADRs are examined across industries, and for a sample of emerging market ADRs.

Preference for Risk in Investing as a Function of Trait Optimism and Gender
James Felton-Central Michigan University
Bryan Gibson-Central Michigan University
David M. Sanbonmatsu-University of Utah

This research examines the role of gender and optimism on the riskiness of investment choices of students (N = 66) in a semester long investment contest with both monetary and academic incentives. Data suggest that males make more risky investment choices than females, and that this difference was primarily due to the riskier choices of optimistic males. In addition, males demonstrated greater variability in final portfolio value than did females. Our results suggest that 1) the well documented gender difference in investment strategies of men and women may be due to a specific subgroup of males (i.e., optimists); 2) that optimism may lead to different behavioral tendencies in men and women depending on the domain; and 3) that the benefits of optimism may be restricted to domains in which continued effort and information seeking are likely to lead to desired outcomes.

Economic Data, Conventions, and Replication in Laboratory Asset Markets
Matthew J. Anderson-Michigan State University
Eugene R. Blue-Howard University

Data extracted from naturally occurring markets and other economic environments often suffer from problems like data confounds and intercorrelations. We report results from a series of experimental markets that suggest some of the data problems can be overcome by using experimental techniques. We use predetermined (videotaped) draws to replicate results from prior research. This is contrary to the conventional wisdom in the literature, which holds that draws should be "live." Our results suggest that the price and allocation behavior of markets can be replicated using predetermined draws to initiate trading. Furthermore, the primary strength of the experimental method-control-is maintained.

Research Elsewhere
Robert A. Olsen-Decision Research

Book Reviews
Robert A. Olsen-Decision Research


Volume 4, Number 2, 2004 Abstracts
Copyright Erlbaum 2003

The Contributions of Daniel Kahneman and Amos Tversky
Hersh Shefrin-Santa Clara University
Meir Statman-Santa Clara University

Does Analyst Optimism About Future Earnings Distort Stock Prices?
Stephen Ciccone-University of New Hampshire

Monthly returns to firms with optimistic expectations are 1.5% lower versus firms with pessimistic expectations, while annual buy-and-hold returns to firms with optimistic expectations are 20% lower. The optimistic component of stock prices lingers months after the optimism is revealed to the market. It also exists separately from the component related to analyst forecast dispersion. The possibility that forecast dispersion is related to transitory versus permanent earnings is proposed.

Anchoring and Psychological Barriers in Foreign Exchange Markets
Frank Westerhoff-University of Osnabrueck

This paper develops a simple behavioral exchange rate model in which investor perception of the fundamental value is anchored to the nearest round number. Traders adjust their anchors in two ways. Some believe that exchange rates move toward (perceived) fundamentals, while others bet on a continuation of the current exchange rate trend. The behavior of the traders causes complex dynamics. Since the exchange rate tends to circle around its perceived fundamental value, the foreign exchange market is persistently misaligned. Central authorities have the opportunity to reduce such distortions by pushing the exchange rate to less biased anchors, but to achieve this, they have to break psychological barriers between anchors.

A Behavioral Decision-Making Modeling Approach Toward Hedging Services
Joost M. E. Pennings-University of Illinois at Urbana-Champaign and Wageningen University, The Netherlands
Math J. J. M. Candel-Maastricht University
Thorsten M. Egelkraut-University of Illinois at Urbana-Champaign

This paper takes a behavioral approach toward the market for hedging services. A behavioral decision-making model is developed that provides insight into how and why owner-managers decide the way they do regarding hedging services. Insight into those choice processes reveals information needed by financial institutions to improve the design of their financial products. The key elements of the model are related to the characteristics of the owner-managers, thereby exploring the decision units' evaluations of the hedging services provided by futures exchanges. Using structural equation models and data from 467 owner-managers, obtained by means of computer- assisted personal interviews, we find that the elements "exercising entrepreneurial freedom," "perceived performance," and the "owner-manager's reference price" determine their attitude toward using futures. These elements are related to innovativeness, risk attitude, and level of understanding of futures markets.

Portfolio Composition Choice: A Behavioral Approach
Uri Benzion-The Technion-Israel Institute of Technology and Ben-Gurion University
Joseph Yagil-Haifa University and Columbia University

This experimental study investigates portfolio composition choice for different types of financial assets and different levels of wealth. For a group of financially sophisticated executive MBA students with work experience in capital markets, the findings of this study indicate that the proportion of wealth invested in risky assets increases with wealth for all portfolio compositions examined, and increases with the degree of asset risk. This proportion is found to be as much as three times higher for common stocks than for options: For stock portfolios, it increases from 33% to 44% over the five wealth levels examined, and for options it increases from 11% to 17%. These results may imply a decreasing rel w proportions of their wealth in risky assets possess the following characteristics: they do not invest in options in real life; they sometimes buy lottery tickets; they assign a higher risk level to options than to common stocks; they are female; and they are employed.

The Effects of Attraction on Investment Decisions
David L. Schwarzkopf-Bentley College

The attraction effect occurs when an inferior item changes a decision-maker's perception of the relationship between other available alternatives, contrary to the expectations of rational decision-making. This study presents the first evidence that this effect, which has appeared persistently in consumer research, can influence investment decisions. The study also finds two distinct patterns of reaction to the inferior item as a sign of "cluster attraction"-a way of spreading investment risk. Evidence of attraction means that the values of important facets of corporate reporting may not be stable across an investor's decisions, but may depend on the items presently available for investment. Results of an experiment conducted with approximately 100 graduate students with investing experience or interest show that the investor's perceived values of reported financial or non-financial performance, quality of earnings, and information source reliability are subject to trade-offs and can be altered by the composition of the decision set, rather than by any intrinsic change in the investment candidate itself. The discussion highlights the implications of these findings for an understanding of how investors regard the qualities of financial reporting.

Robert A. Olsen-California State University

Robert A. Olsen-California State University
Richard L. Peterson-University of Texas at Austin


Volume 4, Number 3, 2004 Abstracts
Copyright Erlbaum 2003

Categorical Thinking in Stock Portfolio Management: A Puzzle?
Isabelle Bajeux-Besnainou-The George Washington University
Kurtay Ogunc-Watson Wyatt Worldwide

"What Goes Up Must Come Down"-How Charts Influence Decisions to Buy and Sell Stocks
Thomas Mussweiler-University of Wurzburg, Germany
Karl Schneller-University of Wurzburg, Germany

Five experiments examine how charts depicting past stock prices influence investing decisions. We expected investors to use extreme past prices depicted in charts as comparison standards to which expectations about future prices are assimilated. Investors should thus expect stocks depicted in a chart with a salient high to perform better than stocks depicted in a chart with a salient low. And as a consequence, investors should be more likely to buy and less likely to sell stocks depicted in a chart with a salient high than a low. Results of five experiments support this reasoning. Whether investors are private or professional and whether background information about the stock was limited or abundant, expectations about future prices assimilated to extreme past prices. Consequently, investors buy more and sell less when the critical chart is characterized by a salient high than a low. The implications of these findings for the core role comparison processes play in investing decisions are discussed.

Profit Warnings and the Pricing Behavior of ADRs
Dave Jackson-University of Texas-Pan American_Jeff Madura-Florida Atlantic University

We assess the pricing behavior of American Depositary Receipts (ADRs) in response to information about their profitability. Specifically, we test for leakage effects and lagged effects, and we assess the cross-sectional variation in market inefficiencies related to profit warnings by foreign firms listed on U.S. stock exchanges as ADRs. Foreign firms experience strong negative valuation effects at the time of the profit warning. Furthermore, there are pronounced leakage effects, which suggests that some market participants were able to capitalize on inside information before the profit warnings were issued. We also find statistically significant evidence of a three-day lag effect following the profit warning, which suggests that investors who did not have inside information could profit from a warning. When using the leakage as a proxy, the degree of market inefficiency is more pronounced for firms in the technology sector, but the extent of government ownership or countries of origin are not significant determinants of market revaluation following a profit warning. Overall, the pricing behavior of ADRs in response to profit information allows for potential arbitrage opportunities.

On Characteristics Momentum
Hsiu-lang Chen-Department of Finance, University of Illinois at Chicago

This article investigates whether investors can benefit from information about equity style evolution. The study shows that portfolios formed by firm characteristics such as size, book-to-market, and/or dividend yield can be used to determine investment style dominance. Characteristics momentum, buying stocks with persistent in-favor characteristics and selling stocks with persistent out-of-favor characteristics, conveys valuable information about future stock returns. It is distinct and has longer-lasting effects than price or industry momentum in predicting future returns. In explaining the existence of characteristics momentum profits, this study highlights the importance of slow evolution of changes in firm characteristics. The lifecycle of investment styles can thus have predictive power for trend-chasing investors, who can potentially push up the price of stocks with an in-favor style, and depress the price of stocks with an out-of-favor style.

Short-Term Overreaction in the Hong Kong Stock Market: Can a Contrarian Trading Strategy Beat the Market?
Isaac Otchere-Department of Finance, The University of Melbourne and University of New Brunswick
Jonathan Chan-Department of Finance, The University of Melbourne

In this paper, we examine the short-run overreaction phenomenon in the Hong Kong market using data from March 1996 to June 1998. The study period encompasses the pre- and post-Asian financial crisis period. Consistent with prior studies on other markets, we find evidence of overreaction in the Hong Kong market prior to the Asian financial crisis. The overreaction phenomenon is more pronounced for winners than losers. While we document evidence of overreaction in the pre-crisis period, we find that abnormal profits obtained from exploiting such a phenomenon are economically insignificant after accounting for transaction costs. Thus, the Hong Kong stock market is efficient in the weak form. We also explore the possibility that the results are affected by factors such as the bid-ask bounce, the size effect, and the day-of-the-week effect. The results, however, are robust to these factors.

Financial Analysts, Firm Quality, and Social Responsibility
Hoje Jo-Leavey School of Business, Santa Clara University

We suggest that financial analysts have an incentive to follow the stocks of socially responsible companies, because such stocks meet the growing demands and psychology of the investment community, who want to combine the usual investment goals with social responsibility. Socially responsible investors prefer to hold stocks of companies they perceive as socially responsible or of high quality. Financial analysts then help brokers' marketing efforts by supplying investors with more analysis for stocks of socially responsible or high-quality companies. Using scores from Fortune surveys on perceptions of community and environmental responsibility as a measure of social responsibility and Fortune survey measures of quality as a measure of company quality, we find evidence that stocks of socially responsible and high-quality companies are indeed followed by more financial analysts. The positive relationship among social responsibility, company quality, and analyst following remains significant even after controlling for the effects on analyst following of firm size, share price, the volatility of stock returns, and market-to-book value of equity.

Research Elsewhere
Robert A. Olsen-California State University, Chico, and Decision Research, Eugene, OR


Volume 4, Number 4, 2004 Abstracts
Copyright Erlbaum 2003

Bubble Jr.
David Dreman-Dreman Value Management

Riding the Wave of Sentiment: An Analysis of Return Consistency as a Predictor of Future Returns
Boyce Watkins-Syracuse University

This article analyzes the degree to which return consistency in the past predicts future returns. I show that consistency is a strong predictive measure for future stock returns. In a portfolio context, positively consistent stocks exhibit positive future risk-adjusted returns, and negatively consistent stocks exhibit negative future risk-adjusted returns. The results are economically and statistically significant over multiple subperiods. Also, odd return behavior persists for nearly two years after portfolio formation. Stocks that have been consistently positive (negative) for longer time horizons have higher (lower) risk-adjusted returns during the followingmonththan those thathavebeenconsistent for shorter time periods. Finally, high consistency enhances momentum when the two factors are allowed to interact. Thus, there appears to be strong path dependence in the momentum effect, and consistency in stock returns appears to be an important component of return predictability.

Investor Confidence and Returns Following Large One-Day Price Changes
Ray R. Sturm-Florida Atlantic University and the University of Central Florida

I hypothesize that post-event price behavior following large one-day price shocks is related to pre-event price and firm fundamental characteristics, and that these characteristics proxy for investor confidence. Several behavioral theories suggest how investors form their expectations, and I suggest four investor confidence hypotheses based on these theories. In addition to documenting further evidence of investor overreaction, my findings indicate that investors respond differently to negative price shocks than to positive price shocks. In particular, large price decreases generally drive positive post-event abnormal returns, while large price increases do not drive positive or negative abnormal returns. However, my main finding is that this relationship is altered when pre-event return and firm characteristics are introduced. This suggests that certain pre-event characteristics influence investor confidence, which in turn influences buying and selling decisions and thereby drives post-event returns. However, investor confidence appears to be lessened by a price shock effect.

Derivation of Asset Price Equations Through Statistical Inference
Gunduz Caginalp-University of Pittsburgh
Vladimira Ilieva-Dreman Foundation
David Porter-George Mason University
Vernon Smith-George Mason University

We develop a methodology to extract a quantitative model for behavioral effects in markets from empirical data. A set of 24 asset market experiments are utilized to derive an equation of price and its dependence on momentum, fundamental value, excess bid level and liquidity considerations. A difference equation is derived from a statistical analysis of the data. The methods are quite general and can be utilized in conjunction with other behavioral finance effects that influence price dynamics.

Simple and Complex Market Inefficiencies: Integrating Efficient Markets, Behavioral Finance, and Complexity
Edgar Peters-PanAgora Asset Management

Traditional capital market theory says that markets are efficient because investors are rational. The new school of behavioral finance says the opposite. Rather than solving problems "rationally," individuals tend to make biased decisions using pattern recognition techniques. However, what is rational and irrational may depend upon the type of problem we wish to solve and the method we use to solve it. If the market inefficiency is a simple objective problem, then "cool reason" should prevail. However, if the market is a complex system, then the value of data would be ambiguous making it more rational to use pattern recognition techniques. In this article we will find that rational investors would indeed keep certain types of mispricing from happening. Likewise, human behavior and the market complexity cause mispricing that cannot be arbitraged away. In the end, investors are irrational if they use the wrong method to solve a particular type of problem. By examining method and object we can find when investors are rational, when they are irrational. A non-mathematical model integrating efficient markets, behavioral finance, and complex systems is presented.

Regression to the Mean: One of the Most Neglected but Important Concepts in the Stock Market
Bernard I. Murstein-Connecticut College

The meaning of "regression to the mean" is discussed, as well as the consequences of failing to recognize its effect on research. The lack of performance persistence among stocks and mutual funds is explained as evidence of a lack of valid variance in the performance of stocks, resulting in steep regression-to-the-mean effects. The ubiquity of regression to the mean is illustrated by showing that it is an important factor in marriage as well as in mutual funds.

Research Elsewhere
Robert A. Olsen-California State University, Chico and Decision Research

Book Review
Robert A. Olsen-California State University, Chico and Decision Research