Volume 7

Volume 7, Number 1, 2006 Abstracts
© Copyright Erlbaum 2006

Prediction Markets and the Financial "Wisdom of Crowds"
Russ Ray-University of Louisville

This paper examines a new genre of behavioral marketsó"prediction" marketsóand their remarkable ability to flush out and thereafter aggregate inside and expert information regarding interest rates, exchange rates, inflation rates, stock prices, commodity prices, and many other economic and financial variables. Comprehensive studies of these markets have found that these markets have "proven to be uncannily accurate in predicting all types of events." Existing in cyberspace and being unregulated, these markets are, arguably, the most efficient financial markets in history.

The Demographics of Overconfidence
Gokul Bhandari-McMaster University
Richard Deaves-McMaster University

As is well-known, investors are subject to overconfidence. Using a survey of about 2,000 defined contribution pension plan members, we not only corroborate this, but also explore the demographics of this behavioral flaw. Noting that overconfidence can be partitioned into certainty and knowledge, we find that highly-educated males who are nearing retirement, who have received investment advice, and who have experience investing for themselves, tend to have a higher certainty level. For some groups knowledge matches certainty. Because highly-educated males do not have higher levels of knowledge we conclude that they are more subject to overconfidence.

Subject Perceptions of Confidence and Predictive Validity in Financial Information Cues
Dorla A. Evans-University of Alabama in Huntsville

Traditional financial theory holds that financial decision makers make choices based on an asset's mean return and its standard deviation in the context of the normal distribution. These statistics, however, may be vague concepts to decision makers, and more difficult to use relative to specific details of a simple discrete probability distribution. Therefore, this study shows which of ten information cues subjects use in making decisions designed to look like simplified bonds, stocks, and options. The cues consist of the mean, standard deviation, and other distribution features such as highest payoff. More importantly, this study relates subjects' usage of various information cues in making financial valuation judgments to their self-assessments of 1) an information cue's ability to best reveal the value of an asset (its predictive validity), and 2) their confidence in using that information cue. The results are related to the overconfidence literature in psychology.

Growth Optimization with Downside Protection: A New Paradigm for Portfolio Selection
Jivendra K. Kale-St. Mary's College of California

This study introduces growth optimization with downside protection as a portfolio selection technique based on power-log utility functions that combine long-term portfolio growth maximization with the behavioral tenets of prospect theory. This simple but powerful technique can be used with all types of assets, including those with highly skewed and fat-tailed return distributions. We use three assets with very different types of return distributions to show how effective this technique is in constructing portfolios with positively skewed returns that combine high upside potential with downside protection.

The Platonic Foundations of Finance and the Interpretation of Finance Models
Elton G. McGoun-Bucknell University
Piotr Zielonka-Warsaw Agricultural University

What is the nature of the collection of mathematical models we call "finance?" There is knowledge in finance, but what is the nature of it, and what is it really about? What sorts of justified true beliefs do we have, i.e., what would it mean for these beliefs/models to be true, and how do we justify their truth? The traditional positive interpretation of finance models poses a number of difficult, and perhaps even intractable, philosophical problems. There are as many as six other interpretations, only one of which, the normative interpretation, is familiar. Most of finance's interpretations of its models, including both of the usual ones, fall within the platonic/foundational perspective as it is applied to mathematics. Even the positive interpretation, to which most in finance implicitly or explicitly subscribe, does not reveal the "objective reality" that is supposed to be out there. We clearly need a truly "behavioral" finance, in every sense of the word.

Research Elsewhere
Robert A. Olsen-Decision Science Research Institute

Book Review
Robert A. Olsen-Decision Science Research Institute

Volume 7, Number 2, 2006 Abstracts
© Copyright Erlbaum 2006

Searching for Rational Investors in a Perfect Storm: A Behavioral Perspective
Louis Lowenstein-Columbia University

Disentangling Cognitive Bias in the Assessment of Investment Decisions: Derivation of Generalized Conditional Risk Attribution
Noriyuki Okuyama-Pareto Investment Management Limited in London
Gavin Francis-Pareto Investment Management Limited in London

Conventional performance measurement methods concentrate on investment outcomes rather than the underlying investment process. This paper examines the effectiveness of the investment process by considering the essential part of any investment strategy: the investment decision. As recognized by Kahneman and Tversky [1979], the essential first step is to decompose returns into gains and losses. Using a fundamental investment decision matrix broadens the analysis beyond realized gains and losses to include an assessment of missed opportunities and losses avoided. This leads to an examination of investment strategies in terms of investment success versus error. We contrast these terms with traditional return and risk measures. The second step is to decompose investment decisions into the mutually exclusive categories of risk-taking and risk-reducing. Uncertainty observed in risk-taking activities is newly created at each manager's discretion, while the uncertainty in risk-reducing activities is already defined by an investor's portfolio. The conventional performance measurement approach fails to differentiate between these two types of decisions. The contrast between passive and active management styles of risk reduction becomes apparent from the perspective of investment success and error, particularly when using currency risk management as an illustration. Active information diagrams describe a geometric approach called conditional risk attribution. An active manager's skill lies in the ability to use information to maximize investment success and therefore minimize investment error. The choice of benchmark determines the degree of visibility of an investment exposure. We also address the problem of distinguishing between an active manager's skill and the uncontrollable impact of market movements. Having adjusted for the bias in an investment environment, it becomes possible, as a final step, to measure the information content of an active manager's strategy as the balance between investment success and error within a generalized conditional risk attribution framework. The unlimited nature of risk-taking decisions is evident when they are included in the framework. However, having defined an ex ante risk-taking limit, we can assess whether the choice of active manager has resulted in an enhancement of investment success over error. This allows investors to compare risk-taking managers with risk-reducing managers in the context of overall portfolio construction. The entire analysis is framed in terms of risk budgeting to demonstrate its general application to all asset classes and consequently to enhance total portfolio returns within the predetermined loss budget.

Money Attitude Typology and Stock Investment
Carmen Keller-University of Zurich
Michael Siegrist-Swiss Federal Institute of Technology in Zurich

This study identifies segments of individual investors based on their money attitudes (attitude toward financial security, attitude toward stock investing, obsession with money, perceived immorality of the stock market, attitude toward gambling, interest in financial matters, attitude toward saving, frankness about finances). A cluster analysis of data from a representative mail survey conducted in Switzerland (N = 1,569) yielded four main segments of individual investors we term safe players, open books, money dummies, and risk-seekers. This typology has forecast value for behavior: Each type differed with regard to having investment portfolios, buying and selling securities, risk tolerance for maximization of capital, response to price fluctuations, and willingness to make environmentally and socially responsible investments.

Expanding the Range of Behavioral Factors in Economic Simulations
H. Joel Jeffrey-Northern Illinois University

Economic simulations typically focus almost exclusively on economic variables. If non-economic factors are included at all, it is usually in some form of utility function calculation. This paper presents a model that allows formal specification of a much broader range of factors, processes, and quantities involved in human communitiesófamilies, businesses, ethnic groups, nations, work teams, cultures. The phenomena include the hierarchically structured social practices of the group, the principles that underlie choices in the community, and the recognizable positions or statuses in the community. This allows us to model intrinsic or expressive behavior, capturing the concept of multi-aspect identity and the impact of the principles of the group on individual behaviors, all in formal and quantitative form. Having these factors represented formally enables the creation of significantly more realistic simulations incorporating a much wider range of variables, particularly when the economic facts and quantities of interest are affected by and affect several other kinds of factors that are not, on their face, economic.

The Disposition Effect and Individual Investor Decisions: The Roles of Regret and Counterfactual Alternatives
Suzanne O'Curry Fogel, DePaul University
Thomas Berry-DePaul University

Recent studies have documented a strong tendency for individual investors to delay realizing capital losses, while realizing gains prematurely (Odean [1996], Shefrin and Statman [1985], Weber and Camerer [1996]). This tendency has been termed the "disposition effect." The disposition effect is inconsistent with normative approaches to stock sales, such as those based on tax losses (see, for example, Constantinides [1983]). We surveyed individual investors, and found that more respondents reported regret about holding on to a losing stock too long than about selling a winning stock too soon. This finding suggests that individual investors are consistently engaging in behavior that they have been warned can cost them money and that they regret later. Two additional experiments confirm the disposition effect and the role of regret, and offer evidence about the role of an agent (broker) in the assignment of blame and regret. We show that investor satisfaction and regret are not simply functions of outcome, but are influenced by counterfactual alternatives and the type of action taken (holding versus selling). We suggest that the disposition effect may be highly related to reduction of anticipated regret.

Research Elsewhere
Robert A. Olsen-California State University and Decision Research in Eugene, Oregon

Volume 7, Number 3, 2006 Abstracts
© Copyright Erlbaum 2006

Did Investor Sentiment Foretell the Fall of ENRON?
Harry F. Griffin-The University of Montevallo

In the aftermath of the ENRON Corporation failure, we acknowledge that many investors experienced a financial loss when their ENRON equity holdings lost market value. Our research centers upon the loss of that market value, and when the capital market first signaled the positive potential of that loss. An examination of ENRON option open interest from January 1, 2000 through December 31, 2001 reveals that such information was available, observable, and inferential a year earlier.

The Impact of U.S. Individual and Institutional Investor Sentiment on Foreign Stock Markets
Rahul Verma-University of Houston-Downtown
Gökçe Soydemir-University of Texas-Pan American

This study examines the degree to which U.S. individual and institutional investor sentiments are propagated abroad. Previous studies construe investor sentiments as fully irrational; we find contrary evidence that individual and institutional investor sentiments are driven by both rational and irrational factors, with distinct effects on domestic and international stock market returns. The generalized impulse response functions from VAR model estimations show that U.S. institutional investor sentiments have varying degrees of impact on the equity markets of the U.K., Mexico, and Brazil, and no effect on Chile. Specifically, the individual investor sentiment effect is statistically significant only for the U.K market. Not surprisingly, the two classes of investor sentiments have a strong significant effect on the U.S. stock market returns. The response of the U.S. to individual investor sentiments is relatively more erratic, while the response to institutional investor sentiments is smoother. This difference in pattern becomes more visible when we consider the response of the foreign stock markets. We find significant effects of rational sentiments of institutional investors on the U.S., the U.K., Mexico, and Brazil. However, there is an insignificant effect of the irrational sentiments on the same set of countries. A direct implication of our empirical evidence is that it is important for international asset pricing models to consider the role of rational sentiments of institutional and individual investors on developed and emerging markets.

Evidence of the Endowment Effect in Stock Market Order Placement
Andreas Furche-Capital Markets Cooperative Research Centre in Sydney
David Johnstone-University of Sydney

The psychological endowment effect is apparent when investors place greater value on something when they mentally "own" it than when someone else owns it. Although this effect is well established in laboratory studies, there is relatively little documented evidence of an endowment bias in actual trading. This study examines order placements of stock traders on the Australian Stock Exchange. Consistent with the endowment effect, sellers appear to value their own shares higher than buyers independent of current market price, by consistently placing sell orders on average "further from the market" (i.e., from the best quote) than buy orders. This asymmetry is more pronounced in private client trading than in orders made through institutional brokers, suggesting that more sophisticated investors are less affected by asset ownership than the private clients of retail brokers. Since private "day traders" have been able to trade online themselves rather than through a broker, the quote asymmetry relative to the best-standing quotes between asks and bids has become more pronounced. Over the same period, the relatively small asymmetry apparent in institutional quotes has remained unchanged.

Firm Image and Individual Investment Decisions
Lucy F. Ackert-Kennesaw State University
Bryan K. Church-Georgia Tech

This paper documents the importance of firm image in individual investment behavior. We conduct three experiments designed to examine whether investment decisions are influenced by selective information disclosures that are intended to promote a positive or negative firm image. Importantly, the disclosures are not value-relevant. Participants actively make investment decisions that have real economic consequences. We find that participants invest more heavily in firms with a positive image than in firms with a negative image, controlling for industry membership and financial data. These results are consistent with economic models of choice that recognize that the financial outcome is not the only argument in a person's utility function.

The Characteristics of Online Investors
Konari Uchida-The University of Kitakyushu

Research Elsewhere
Robert A. Olsen-California State University and Decision Science Research Institute in Eugene, Oregon

Book Reviews
Robert A. Olsen-California State University and Decision Science Research Institute in Eugene, Oregon

Exuberant Irrationality: Judging Financial Books by their Covers
Andrew Coors – Laffer Associates
Lawrence Speidell – Ondine Asset Management

A Literature Review of Social Mood
Kenneth R. Olson – Fort Hays State University

Emotions exert a significant influence on financial behavior. The "socionomic hypothesis" posits social mood, the collective mood of individuals, as a primary causal variable in financial and social trends. In order to provide a scientific basis for the study of social mood, this article reviews psychological research on major mood-related elements of personality: affect, motivation, and personality traits. We examine the structure and functions of these core personality dimensions, and discuss research on contagion processes by which individuals' moods spread and manifest in a collective social mood. We also address implications for financial and economic behavior. Social mood is rooted in empirically established personality dimensions that are fundamental to human nature, and can influence financial outcomes.

Status Quo Bias and the Number of Alternatives: An Empirical Illustration from the Mutual Fund Industry
Alexander Kempf – University of Cologne
Stefan Ruenzi – University of Cologne

We examine the extent of the status quo bias (SQB) in a real-world repeated decision situation. Individuals who are subject to the SQB tend to choose an alternative that they chose previously (i.e., their status quo), even if it is no longer the optimal choice. We examine the U.S. equity mutual fund market and find strong evidence of the SQB. Furthermore, the SQB is more severe in segments that have more funds to choose from. Thus, we deliver the first empirical confirmation of the experimental results of Samuelson and Zeckhauser [1988] that the SQB depends positively on the number of alternatives.

Recall of Financial Information for Investment Decisions: The Impact of Encoding Specificity and Mental Imagery
Kenneth Ryack – Connecticut State University
Thomas Kida – University of Massachusetts

Given the volume of data analyzed in investment decisions, analysts and investors often must rely on their memory of financial information. Prior research suggests that differences in the amount of information used by investors may affect their valuation of securities and market prices. Thus, factors influencing the amount and accuracy of information recalled could impact estimates of stock value and market prices. Financial information is often presented in different formats. This study examines whether differences in format presentation at encoding and retrieval affect the recall of financial data. We also investigate whether memory for financial information can be improved with a simple technique that uses mental imagery to reinstate the original encoding conditions. We find that even a minor change in the presentation format has significant effects on memory for financial information. Our results also suggest that the use of mental imagery to reinstate the original format may significantly improve memory for financial data.

Mimicking Behavior in Repurchase Decisions
Mike Cudd – Mississippi College
Harold E. Davis – Southeastern Louisiana University
Marcelo Eduardo – Mississippi College

Behavioral biases associated with base rate neglect, anchoring, ambiguity aversion, and robust control may foster an environment in which mimicking may influence decision-making. This study tests for the presence of mimicking behavior in security repurchase decisions. After controlling for variables reflecting financial operating motives and mispricing associated with limits to arbitrage, results show that debt-equity choices in repurchase events are significantly enhanced by the occurrence of recent similar choices made by the firm's competitors. Specifically, the probability of opting to repurchase equity (debt) is positively associated with the size of the firm conducting the largest percentage equity (debt) repurchase in the same industry in the prior year. Moreover, the mimicking activity is observed for smaller-sized firms, but not for larger firms. The findings are consistent with the premise that managers of smaller firms are generally less skilled and experienced, and more prone to be influenced by decision shortcuts such as mimicking the actions of peers.

Research Elsewhere
Robert A. Olsen-California State University and Decision Science Research Institute in Eugene, Oregon

Book Reviews
Robert A. Olsen-California State University and Decision Science Research Institute in Eugene, Oregon