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Animal Spirits

Are investors and traders cats, rationally and independently sniffing out returns? Or are they cows, flowing with a herd that must know something? These blog entries relate to behavioral finance, the study of the animal spirits of investing and trading.

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Local Bias and Regional Abnormal Returns: Invest in Depressed States?

Does bias on the part of U.S. investors in favor of companies headquartered within their home states create opportunities for geographical abnormal returns? In the February 2008 draft of their paper entitled “Long Georgia, Short Colorado? The Geography of Return Predictability”, George Korniotis and Alok Kumar investigate whether the behavior of local investors in response to local economic conditions produces predictable patterns in the returns of local stocks. They define local as individual U.S. states. They define local economic conditions as the combination of: (1) growth rate of state labor income; (2) state unemployment rate relative to a moving average; and, (3) state-level housing collateral ratio (as a measure of borrowing constraints). Using quarterly state-level economic data, company headquarters locations and quarterly stock return data for 1980-2004 (covering a total of 39 states as limited by sample size), they conclude that: Keep Reading

The Behavioral Asset Pricing Model

Do investors price stocks based mostly on rational analysis or feelings? In their February 2008 paper entitled “Affect in a Behavioral Asset Pricing Model”, Meir Statman, Kenneth Fisher and Deniz Anginer use survey results to investigate both the objective and subjective (perceived) connections between risk and return. Using results of: (1) the 1982-2006 annual Fortune surveys of senior executives, directors and security analysts regarding the long-term investment value of companies; and (2) May and July 2007 surveys of high-net worth clients of a large investment firm, they conclude that: Keep Reading

Unconditional Love for Losers?

Do investors love their losers more than their winners? In their January 2007 paper entitled “The Effect of Prior Beliefs and Preferences on Information Processing in an Investment Experiment”, Jeremy Ko and Oliver Hansch use a stock picking simulation to measure the bias investors exhibit when processing new information about stocks they have selected. Each iteration of the simulation involves picking one of two similar stocks that will outperform during the coming week. Using results from simulations involving 99 total participants in 2003 and 2004, they conclude that: Keep Reading

The Belief Component of Risk Premiums

Is risk premium variation principally a consequence of changes in objective business conditions, or is some human dynamic important? In their November 2007 paper entitled “Diverse Beliefs and Time Variability of Risk Premia”, Mordecai Kurz and Maurizio Motolese examine the effect of diverse but individually rational market beliefs on risk premiums. They define belief as a variable independent of all observed fundamentals, with its own dynamic that reflects changes in the distribution of investor risk perceptions. Using monthly interest rate forecasts compiled by Blue Chip Financial Forecasts since 1983 to measure market beliefs and associated actual interest rate data, they conclude that: Keep Reading

99 Cents Is Not a Sale Price

Do round numbers have a special meaning for stock traders? If so, is there a way to exploit any associated trading tendencies? In their 2007 paper entitled “Round Numbers and Security Returns”, Edward Johnson, Nicole Johnson and Devin Shanthikumar examine returns (calculated based on midpoints of subsequent closing bid and ask prices) after closing prices that are just above or just below round numbers. Using closing price and closing bid-ask data and firm characteristics for a broad sample of U.S. stocks during the post-decimalization period of 5/01-12/06, they conclude that: Keep Reading

Jim Cramer’s Gaps and Reversals

Are Jim Cramer’s stock recommendations on CNBC’s Mad Money most meaningful for small-capitalization stocks, for which prices are most susceptible to influence by the concerted behavior of a group of individual investors? In their September 2007 working paper entitled “The Performance and Impact of Stock Picks Mentioned on Mad Money, Bryan Lim and Joao Rosario evaluate the show’s ability to move markets over the short term and to forecast winners and losers over the long term. Using a sample of 10,589 Mad Money buy and sell recommendations representing 2,074 distinct firms, either initiated by Jim Cramer or provided by him in response to callers, from shows aired between June 28, 2005 and December 22, 2006, they conclude that: Keep Reading

Anger Management Training for Traders?

Do strong emotions generally help or hinder trading? How do outperforming traders handle their emotions? In the 2007 paper entitled “Being Emotional during Decision making – Good or Bad? An Empirical Investigation”, flagged by reader Dennis Page, Myeong-Gu Seo and Lisa Feldman Barrett investigate the role of emotions in stock trading via a simulation involving 101 traders recruited from investment clubs and paid $100 to $1,000 based on performance during the simulation. Using the self-reported emotional states of these traders during simulated buy-sell decisions on 12 available stocks each day for 20 consecutive trading days, they conclude that: Keep Reading

Thrill Factor: The Stock Market as Amusement Park?

Has disintermediation of trading, enabled by the Internet, changed the level of risk that individual investors/traders routinely assume? In his 2005 paper entitled “Where the Action is: Internet Stock Trading as Edgework”, Detlev Zwick argues that the transition of stock trading from pre-Internet communication modes (telephone, fax and in-person) to the computer screen creates new types of individual experiences and practices that existing economic and finance theories do not predict or understand. Using in-depth oral interviews extended by email follow-ups with 25 experienced online investors in Germany, Denmark, and the United States during 2000-2002, he concludes that: Keep Reading

Stock Returns After T-bill Yield Shocks

During a crisis, do investors overreact in reallocating funds from risky assets (stocks) to safe 13-week Treasury bills (T-bill), with stock prices and T-bill yields consequently falling together? Once the crisis abates, do investors cthen orrect their overreaction by moving funds back from T-bills to stocks, with stock prices and T-bill yields then rising together? To test this model of investor behavior, we examine relationships between overall stock market returns and T-bill yield changes during and after dramatic declines in the T-bill yield for past and future intervals of 10, 21 and 63 trading days. Using daily closes for the S&P 500 index and T-bill yield from 1/4/60 through 8/20/07 (11,864 days when both traded), we find that: Keep Reading

Naive Investors: Illusions of Personal Past Performance

Do individuals understand their actual aggregate investing/trading performance? In their July 2007 paper entitled “Why Inexperienced Investors Do Not Learn: They Don’t Know Their Past Portfolio Performance”, Markus Glaser and Martin Weber measure whether individual investors can correctly estimate personal absolute and relative stock portfolio performance. Using the responses of 215 online investors to a 2001 internet survey and actual portfolio returns for these investors during 1997-2000 as calculated from their holdings during that period, they find that: Keep Reading

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