Volume 9

Volume 9, Number 1, 2008 Abstracts
© Copyright Taylor & Francis, LLC. 2008

Commentary: Cognitive Dissonance: The Problem Facing Behavioral Finance
Robert A. Olsen - Decision Research

Bursting Bubbles: Linking Experimental Financial Market Results to Field Market Data
Julia Henker - University of New South Wales, Sydney, Australia
Sian Owen - University of New South Wales, Sydney, Australia

The laboratory, where variables can be measured and controlled, is perhaps the most efficient place to test scientific theory, yet in general empirical financial research neglects experimental finance results. We link laboratory findings to actual, or field, data, applying the Smith, Suchanek and Williams [1988] experimental market model to Australian stock exchange data. We introduce modifications that improve the model's fit to field market conditions. The experimental model is a reliable predictor of field market bubble bursts in more than 50% of the cases we test, and our modifications improve the performance to 77% of the cases. Our results suggest that experimental financial market results should be accorded more attention in empirical research.

Giving Credit Where Credit is Due: The Psychology of Credit Ratings
Vanessa Gail Perry - George Washington University

The purpose of this study is to examine the effect of personality on credit ratings, measured in terms of credit scores from actual credit reports. Personality is measured in terms of an individual's locus-of-control, which is the extent to which individuals attribute important outcomes to external forces outside of their control. Using survey data from a large, national sample of consumers, an individual's credit score is modeled as a function of financial knowledge and locus-of-control, in addition to demographic characteristics and situational factors. Findings suggest that consumers with higher levels of financial knowledge and consumers with an internal locus-of-control have higher credit scores than similarly situated consumers with low credit scores, even after controlling for income, education, and the incidence of negative external life events. In addition, the extent to which knowledge affects credit scores depends on whether an individual has an external vs. internal locus-of-control.

Ambiguity Aversion and Illusion of Control: Experimental Evidence in an Emerging Market
Breno Grou - Universidade de Brasilia
Benjamin M. Tabak - Banco Central do Brasil and Universidade Catolica de Brasilia

This paper investigates behavioral effects known as illusion of control and ambiguity aversion using an experiment with business and economics students in Brazil. Empirical results suggest that people present both ambiguity aversion and illusion of control. Nonetheless, most agents are not willing to pay a premium to reduce or eliminate ambiguity aversion and to gain “control.” These results share some similarities with results for developed markets, but it seems cultural differences may play a role in these results.

Dividend and Taxes, Redux, … Again
George M. Frankfurter - Louisiana State University
Arman Kosedag - Berry College
Bob G. Wood Jr. - Tennessee Tech University
Haksoon Kim - Louisiana State University

In this paper we study the effect of The Job Growth and Taxpayer Relief Reconciliation Act of 2003 on dividend payouts of two types of firms. Using a sample of traditional (predisposed to paying dividends) and growth-oriented (paying dividends only to satisfy stockholders' demands) firms, we show that dividend payouts increased before the tax law changed and continued to rise, thereafter. In addition, the differences across the two types of firms disappeared, most likely because to increases in firm size. Thus, although the reduced tax rate on personal dividend income might have been a reason for the increase, there must have been other factors in play, too. We also conclude that the dividend decision not just varies, but that it also matters.

A Detailed Prospect Theory Explanation of the Disposition Effect
Raymond Dacey - University of Idaho
Piotr Zielonka - Warsaw University of Life Sciences

The disposition effect has been characterized in various ways: the “effect, whereby investors are anxious to sell their winners, but reluctant to sell their losers” (Shefrin [2005], pp. 419); “the tendency to hold losers too long and sell winners too soon” (Odean [1998], pp. 1775) and the effect, whereby investors “sell winners more readily than losers” (Odean [1998], pp. 1779). The most discernable aspect of these characterizations is their imprecision, particularly with regard to time. In what follows, we provide a detailed explanation of the disposition effect based on a straightforward application of prospect theory (Kahneman and Tversky [1992]; Kahneman and Tversky [1979, 2000]). The analysis begins with the traditional account of the disposition effect (Shefrin and Statman [1985]) and provides precise time-independent concepts that replace “sell too soon” and “hold too long.” The analysis shows when the prospect theory explanation of the disposition effect requires only the valuation function and when the explanation requires both the valuation function and the probability weighting function.

Volume 9, Number 2, 2008 Abstracts
© Copyright Taylor & Francis, LLC. 2008

Commentary: Moving from an Efficient to a Behavioral Market Hypothesis
Donald J. Smith - Boston University

Behavioral finance typically is introduced in investments courses in the context of the efficient markets hypothesis (see, e.g., the widely used textbooks by Bodie, Kane, and Marcus [2002] and Reilly and Brown [2003]). This note offers a diagrammatic approach to “position” visually behavioral finance between the information available to market participants and their investment decisions.

Biases in Individual Forecasts: Experimental Evidence
Lucy F. Ackert - Kennesaw State University
Bryan K. Church - Georgia Tech
Kirsten Ely - Sonoma State University

Trueman [1994] provides a model of forecasting behavior in which analysts do not always make forecasts that are consistent with their private information. Using Trueman's model to provide theoretical direction, we conduct six experimental sessions to investigate individual forecasting behavior. In each session, four individuals predict earnings based on possibly divergent information. We manipulate forecast ability so that two individuals are strong analysts and two are weak. In three sessions, forecasts are released simultaneously. We find that forecasts do not always reflect private information. Both weak and strong analysts make forecasts that are inconsistent with private information, although the behavior is much more pronounced for weak analysts. In another three sessions, forecasts are released sequentially. We find that weak second analysts engage in herd behavior: that is, they mimic the reporting behavior of the first analyst. In contrast, strong second analysts are unaffected by the reporting behavior of the first analyst. The overall findings are consistent, in spirit, with the forecasting behavior suggested by Trueman [1994].

The Stock Market Bubble, Shareholders' Attribution Bias and Excessive Top CEO Pay
Gueorgui I. Kolev - Universitat Pompeu Fabra, Barcelona, Spain

I use aggregate time series data on profits in the corporate sector, Standard and Poor's Composite Stock Price Index, and the average total pay of the top 100 CEOs to look for evidence in favor or against a fundamental attribution bias-based explanation of the recent explosive growth in CEO pay. I hypothesize that shareholders overattribute prominent increases and decreases in the prices of corporate stocks to the leadership and skill of the CEOs and underplay the role of stock market fluctuations, which are beyond CEO control. I recast this hypothesis as a simple endogeneity test, and I cannot reject the view that market fluctuations mechanically cause changes in CEO compensation with no detectable reverse causality. Further I find that, in the aggregate data increases in CEO pay decrease corporate profits. To complement the time series evidence, I use 4-factor model risk-adjusted returns as a direct measure of CEO skill. I show that in the cross section the relationship between individual CEO pay and skill is very weak (economically small and statistically insignificant). I conclude that in the late1990s stock market bubble period shareholders were taken for a ride and ended up paying huge amounts of money to their CEOs for no rational reasons.

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.

Interactions of Individuals' Company-Related Attitudes and Their Buying of Companies' Stocks and Products
Jaakko Aspara - Helsinki School of Economics
Henrikki Tikkanen - Helsinki School of Economics

Although increasingly interested in individual investors' behavior and psychology, finance research has paid little attention to the fact that the same individuals who engage in investment behavior and trading of stocks of certain companies may also engage in other economic behavior, notably in the consumption of products. Recognizing this, as well as the increasing evidence of the role of company-related attitudes in individuals' investment behavior, the article presents a theoretical model concerning how an individual's company-related attitudes, his/her tendency to buy/hold the company's stocks, and his/her tendency to buy/use the company's products are likely to interact. The proposed interaction is suggested to generate a potentially considerable leverage effect, ultimately on the stock price of a company.

Is Satisficing Absorbable? An Experimental Study
Werner Guth - Max Planck Institute of Economics
M. Vittoria Levati - Max Planck Institute of Economics
Matteo Ploner - Max Planck Institute of Economics

We experimentally investigate whether the satisficing approach is absorbable, that is, whether it still applies when participants become aware of it. In a setting where an investor decides between a riskless bond and either one or two risky assets, we familiarize participants with the satisficing calculus applied to specific portfolio selection tasks. After experimenting with this calculus repeatedly, participants can either continue using it or select their portfolio freely. The results reveal some absorbability of the satisficing approach in the simpler two-state setting, whereas more complexity renders the satisficing heuristics more difficult and their absorption less likely.

Volume 9, Number 3, 2008 Abstracts
© Copyright Taylor & Francis, LLC. 2008

A Face Can Launch a Thousand Shares—And an 0.80% Abnormal Return
Matteo P. Arena - Marquette University
John S. Howe - University of Missouri-Columbia

In this paper we examine the market reaction—price and volume—to the appearance of a firm in the Who's News column of The Wall Street Journal. We differentiate between those firms whose articles are accompanied by a picture of an executive and a control set of firms whose articles on the same day are not accompanied by a picture. The results show a more pronounced market reaction to the “cum picture” articles, consistent with the incomplete information theory of Merton [1987] and the heuristic-based familiarity hypothesis. There is no evidence of significant long-run abnormal performance for the sample firms.

The Impact of Investor Status on Investors' Evaluation of Negative and Positive, Separate and Combined Information
Anna M. Cianci - LeBow College of Business, Drexel University

This paper examines the impact of investor status (current and prospective) on investors' evaluation of information varying in valence (positive and negative) and in presentation mode (simultaneous and sequential). MBA graduates, proxying for investors, rated the relevance of positive and negative company information and the attractiveness of the company as an investment. Results indicate that (1) current (but not prospective) investors' relevance and attractiveness ratings are more favorable when negative information is presented sequentially (compared to simultaneously) with other negative information; (2) investors' investment attractiveness ratings are more favorable when negative and positive information are simultaneously (compared to sequentially) presented; and (3) investors' relevance and investment attractiveness ratings are more favorable when positive information is presented sequentially (compared to simultaneously) with other positive information. These findings are generally consistent with the psychological phenomena of multiple loss aversion, loss buffering, and gain savoring, respectively.

Risk Preference Discrepancy: A Prospect Relativity Account of the Discrepancy Between Risk Preferences in Laboratory Gambles and Real World Investments
Ivo Vlaev - University College London
Neil Stewart - University of Warwick
Nick Chater - University College London

In this article, we presented evidence that people are more risk averse when investing in financial products in the real world than when they make risky choices between gambles in laboratory experiments. To provide an account for this discrepancy, we conducted experiments which showed that the range of offered investment funds that vary in their risk-reward characteristics had a significant effect on the distribution of hypothetical funds to those products. We also showed that people are able to use the context provided by the choice set in order the make relative riskiness judgments for investment products. This context dependent relativistic nature of risk preferences is proposed as a plausible explanation of the risk preference discrepancy between laboratory experiments and real-world investments. We also discuss other possible theoretical interpretations of the discrepancy.

Portfolio Selection of German Investors: On the Causes of Home-biased Investment Decisions
Andreas Oehler - Bamberg University
Marco Rummer - Bamberg University
Stefan Wendt - Bamberg University

Real-world portfolio composition is often far from being mean-variance optimal. One of the phenomena documented in investment portfolios is the home-bias effect, that is, investors hold a higher-than-optimal portion of domestic assets. Analyzing hand-collected data from annual reports of German mutual funds, we find strong evidence for home-biased portfolio selection in the years 2000-2003. Besides this we document a “Europe bias,” that is, equities from European countries are strongly overrepresented. Furthermore, bounded rationality of private investors appears to drive suboptimal portfolio selection. The behavior and skill of mutual fund managers seems not to influence the overall home bias.

Are Pension Fund Managers Overconfident?
Christoph Gort - Harcourt Investment Consulting AG
Mei Wang - Swiss Banking Institute, University of Zurich
Michael Siegrist - Institute for Environment Decisions and Consumer Behavior at Swiss Federal Institute of Technology

Empirical studies show that people tend to be overconfident about the precision of their knowledge, leading to miscalibration. Consistent with this, we found that on overage the decision makers of Swiss pension plans provide too narrow confidence intervals when asked to estimate past returns of various assets. Their confidence intervals are also very narrow in their forecasts of future returns. They are less miscalibrated, however, than our laypeople sample. Individual differences between the participants' degree of overconfidence are large and stable across those two different tasks. In a linear regression model we present evidence that the size of participants' confidence intervals is linked to individual characteristics. In our sample younger people with a degree from university and with more experience in finance provide larger intervals than older people without such an education and with less experience.

An Analysis of Financial Analysts' Optimism in Long-term Growth Forecasts
Byunghwan Lee - School of Business Administration, California State Polytechnic University, Pomona
John O'Brien - Tepper School of Business, Carnegie Mellon University
K. Sivaramakrishnan - C.T. Bauer College of Business, University of Houston

A large body of literature has rejected rational expectations in relation to analyst forecasts. In this paper we start with a boundedly rational premise that analysts and managers adopt are influenced by the availability heuristic (Tversky and Kahneman [1973]). In the presence of business cycles, a rational growth forecast presupposes precise knowledge of the factors that cause a business cycle. In contrast, under the availability heuristic the current state is overweighted in the growth forecast and so whatever part of the business cycle the economy is currently in will be preserved by the investment decision. As a result, under the hypothesis of the availability heuristic we will observe ex-post, a systematic association between the drivers of this behavior (e.g., current state of the economy, industry, current performance) and subsequent forecast errors and (realized) growth when related to specific properties of the business cycle. We test for this condition and find evidence in support of it. The boundedly rational premise also provides a prediction for the nature of information that can improve analyst forecasts. The results from our analysis provide support for conclusion that a major driver of the boundedly rational behavior is ignoring the business cycle. Together these results provide direct evidence in support of Sargent's [2001] conjecture that a plausible reason for departures from rational expectations is the overly strong assumptions regarding the knowledge the agents are assumed to possess regarding the underlying laws of motion for the economy.

Commentary: Predicting Relative Performance in Economic Competition
Jeffrey Hales - Georgia Institute of Technology
Steven J. Kachelmeier - University of Texas, Austin

Recent research in psychology has challenged the notion of a systematic “better-than-average” bias in predicted relative performance. Extending this research, we show that in an incentive-compatible experimental competition with widespread variation in abilities, those who are better than average tend to overestimate their actual performance, while those who are worse than average tend to underestimate their actual performance. We then demonstrate that this symmetric miscalibration at both sides of the relative performance distribution can facilitate optimal choices of costly insurance to mitigate performance-based risks. In contrast to the findings of prior research, we find that, after taking this insurance into account, participants are no worse off when economic risks are based on relative performance than when risks are assigned randomly in a similarly structured control setting.

An Intimate Portrait of the Individual Investor
Robert B. Durand - University of Western Australia
Rick Newby - University of Western Australia
Jay Sanghani - University of Western Australia

We examine a range of investment decisions, and ensuing portfolio performance, and established that they have statistically significant associations with personality traits captured by Costa and McRae's [1992] operationalization of Norman's [1963] 'Big Five' (Negative Emotion, Extraversion, Openness to Experience, Agreeableness and Conscientiousness), Bem's [1977] psychological gender traits (Masculinity and Femininity) and Jackson's [1976] personality traits of Preference for Innovation and Risk Taking Propensity.

The Role of Psychic Distance in Contagion: A Gravity Model for Contagious Financial Crises
Lili Zhu - Shenandoah University
Jiawen Yang - George Washington University

We synthesize the financial crisis contagion literature through the gravity model from physics and test the hypothesis that the severity of contagion relates positively to trade and financial linkages but negatively to psychic distance between countries, when macroeconomic fundamentals and institutional factors are controlled. The psychic distance variable, a behavioral predictor constructed along four dimensions including geographic distance, common language, development level and common membership, is of key interest in this study. Using data of financial crises originated in Mexico, Asia, Russia, and Brazil in the 1990s, we find empirical support for the hypothesis, particularly for the importance of psychic distance in analyzing financial crisis contagion.

Why Do Bond and Stock Prices and Trading Volume Change around Credit Rating Announcements?
Dror Parnes - University of South Florida

It has been well documented that stock prices, bond prices, and trading volume significantly fluctuate around credit rating announcements. Existing literature suggests three alternative theories to rationalize these phenomena. Yet each competing premise can explain only a piece of the puzzle. This study contests these theories and presents a substitute behavioral approach. Our setting leads to a complete and better explanation of the increased trading volume prerating announcement, the significant price movements post-credit announcements, the larger loss post downgrade for low credit categories versus high credit grades, and the stronger loss post downgrade versus gain post upgrade.

The Relationship Between Investor Attachment Style and Financial Advisor Loyalty
Donalee Brown - Fairleigh Dickinson University
Zane E. Brown - Lord Abbett & Co.

The advent and evolution of behavioral finance has brought with it a revolution in the finance industry. Despite all its resources and infrastructure the investment advisory business often results in frustrating and ineffective advisor/client relationships. Using the principles of behavioral finance, the current study explores the psychological concept of individual attachment style and applies it to the relationship construction between the financial advisor and client. Results provide valuable information to the financial advisor in detecting and understanding different client characteristics that can help lead to productive, satisfactory advisor/client relationships.

Effects of Managerial Discretion in Fair Value Accounting Regulation and Motivational Incentives to “Go Along” with Management on Analysts' Expectations and Judgments
Ruth Ann McEwen - Suffolk University
Cheri R. Mazza - Fordham University
James E. Hunton - Bentley University

The current study examines the extent to which financial analysts expect firms to manage earnings when accounting rules allow a relatively high degree of discretionary choice and low level of transparency, and measures whether analysts' stock price estimates are upwardly biased when they are aware that management is taking advantage of the situation. We further investigate whether analysts' expectations and judgments in this regard are amplified in the presence of an incentive to “go along” with management's misleading financial information. A total of 44 experienced financial analysts participate in a between-participants experiment, wherein those who are provided with misleading (non-misleading) information from management regarding the fair value of an impaired asset for which there is no active exchange market, expect management to recognize a downwardly biased (non-biased) asset impairment loss and issue commensurately higher (lower) stock price estimates. The results also show that analysts who have an incentive to go along with management anticipate a downwardly biased impairment loss and provide a higher stock price estimate, relative to analysts with no such incentive. Finally, the research findings indicate a significant interaction whereby the differential responses from analysts in the truthful and misleading conditions are greater in the presence, compared to absence, of an incentive go along with management.