Animal Spirits

Proponents of rational markets build on a common-sense foundation of reward for risk, with price variability (beta) as the fundamental risk. Since this single source of risk does not predict asset prices very well, rationalists have empirically appended to their models other sources of risk (proxied by size, value and momentum factors) in search of better predictions. Proponents of behavioral finance counter with innate cognitive and emotional biases (irrationality) as causes of rational model failures. Is there a way to prove one of these two views more correct? Should rationalists look for additional risk factors? Does some third perspective offer insight? In their January 2007 preliminary paper entitled “Failure of Asset Pricing Models: Transaction Cost, Irrationality, or Missing Factors” Joon Chae and Cheol-Won Yang tackle these questions. Using monthly stock return data for 700 Korean firms over the period December 1997 to November 2004 (84 months), along with associated measures for both potential degree of trader rationality (sophistication) and transaction costs, they conclude that: Keep Reading

…is fear as a sales pitch. Keep Reading

What is the role of journalists in the stock selection process? Are they experts, signal amplifiers or noise amplifiers? Is their collective view short-term or long-term? In two recent papers, Alexander Kerl and Andreas Walter examine the nature and value of the stock filtering role of journalists writing for German personal finance magazines (such as Effecten-Spiegel and Börse Online). Keep Reading

Is more investment information always better? Are there unintended consequences for individual investors/traders acquiring investment information? Specifically, do individual investors/traders systematically acquire information to support rational future decision-making, or do they focus on information that confirms (and builds overconfidence in) decisions already made? The following two recent studies examine these questions, with results as follows: Keep Reading

Are investor actions well-calibrated when they punish or reward the stocks of all the companies in an industry based on the earliest earnings announcements among peer companies? In the December 2006 version of their paper entitled “Overreaction to Intra-Industry Information Transfers?”, Jacob Thomas and Frank Zhang test the efficiency of intra-industry information transfers by measuring whether the price responses of non-announcing firms to earlier peer group earnings announcements systematically relate to subsequent price responses when these same companies announce their own earnings a few days later. Using a sample of earnings announcement dates, stock returns and firm financial variables spanning 132 quarters over 1973-2005 (245,742 firm-quarter observations), they conclude that: Keep Reading

Do investors really sell winners and hold losers, thereby helping the market beat them? In other words, are they reluctant to admit mistakes? In their November 2006 paper entitled “Is the Aggregate Investor Reluctant to Realize Losses? Evidence from Taiwan”, Brad Barber, Yi-Tsung Lee, Yu-Jane Liu and Terrance Odean investigate whether the average investor exhibits the disposition effect, the tendency to sell winning investments at a faster rate than losing investments. Using data for all trades on the Taiwan Stock Exchange during 1995-1999 (over one billion trades by nearly four million traders), they conclude that: Keep Reading

Do mutual funds that implement the tenets of behavioral finance, in defiance of the Efficient Market Hypothesis, outperform? Can they find and exploit systematic behavioral mispricings? In their August 2006 paper entitled “Behavioral Finance: Are the Disciples Profiting from the Doctrine?”, Colby Wright, Prithviraj Banerjee and Vaneesha Boney assess whether expert investors have validated the principles of behavioral finance by examining the aggregate performance of a group of mutual funds that practice them. Using equal-weighted data for 16 mutual funds most visibly associated with behavioral finance (see table below), they find that: Keep Reading

A reader observed and asked: “I read today that Peter Dolan, the CEO of Bristol-Myers Squibb (BMY), left the company…BMY was up nearly 4% at the open. How many other times have CEOs of unprofitable/unloved publicly traded companies gotten sacked and the share price rises on the news? Could this be a market inefficiency that market makers and traders (i.e., hedge funds) exploit to the chagrin of individual and institutional investors (mutual funds)? Does a publicly traded company with a stock price stagnant for years get a trader’s premium when a management change occurs?” Keep Reading

Does touting of penny stocks via email spam work? If so, for whom? In their July 2006 paper entitled “Spam Works: Evidence from Stock Touts and Corresponding Market Activity”, Laura Frieder and Jonathan Zittrain assess the impact of unsolicited email touting on Pink Sheet stock prices. They also investigate who wins and who loses from such attempted manipulation. They construct their test sample from 75,415 unsolicited email messages touting a total of 307 mostly Pink Sheet stocks between January 2004 and July 2005, along with associated price and volume data for these stocks. They then create a control sample of randomly selected comparable Pink Sheet stocks. By comparing the test and control samples, they conclude that: Keep Reading

Can traders exploit irrational reactions to Jim Cramer’s stock recommendations by viewers of CNBC’s Mad Money? In their March 2006 paper entitled “Is the Market Mad? Evidence from Mad Money“, Joseph Engelberg, Caroline Sasseville and Jared Williams measure the market’s reaction to Mr. Cramer’s buy recommendations. Using a sample of 246 initial recommendations made by Jim Cramer on Mad Money episodes between July 28, 2005 and October 14, 2005, as recorded by YourMoneyWatch.com, they conclude that: Keep Reading