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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.

An Overview of Investor Animal Spirits

What formal studies does academia have to offer on the role of emotions in equity investing/trading? In their October 2004 paper entitled “The Role of Feelings in Investor Decision-Making”, Michael Dowling and Brian Lucey synthesize the results of two threads of recent areas of research on whether and how emotions affect investing: (1) mood misattribution (the impact of environmental factors, such as the weather, the body’s biorhythms and social factors); and (2) image (how investors feel about companies separately from any financial analysis). They note that: Keep Reading

Finding Memes for Contrarian or Trend-following Plays

The Internet enables rapid flow and ebb of trading memes. Trend followers hope to ride a meme and get out before it fades. Contrarians take the other side in anticipation of the fade. Traditional tools for inferring memes include price-volume action and market sentiment. Do emerging information-filtering technologies present novel ways of discovering investing/trading memes from surges of news on the web? Building on ideas offered in the article “Finding Signals in the Noise” from Technology Review, we offer a few possible meme-detectors: Keep Reading

Classic Paper: Emergence of Behavioral Finance

We have selected for retrospective review a few all-time “best selling” research papers of the past few years from the General Financial Markets category of the Social Science Research Network (SSRN). Here we summarize the October 2002 paper entitled “From Efficient Markets Theory to Behavioral Finance” (download count over 4,100) by Robert Shiller, author of the book Irrational Exuberance. This paper traces the recent history of financial market research, from an erosion of faith in the efficient markets theory to a growing collaboration between the social sciences and finance. Shiller’s key points are: Keep Reading

The Ghosts of Stocks Past

In their September 2004 paper entitled “Once Burned, Twice Shy: How Naive Learning and Counterfactuals Affect the Repurchase of Stocks Previously Sold”, Terrance Odean, Michal Strahilevitz and Brad Barber examine how past experience with a stock affects the average investor’s subsequent actions regarding that stock. Using trading records for 66,465 households at a large discount broker during 1991-1996 and 665,533 investors at a large retail broker during 1997-1999, they show that the average investor tends to: Keep Reading

Unbalanced Attention?

Given the vast amount of information available, investors must filter source data ruthlessly. In their May 2005 paper entitled “Investor Attention, Overconfidence and Category Learning”, Lin Peng and Wei Xiong model investor allocation of attention to markets/sectors and stocks and examine how attention allocation process affects asset prices. Emphasizing that attention is a scarce cognitive resource, they find that: Keep Reading

Investing Like an Optimist

In the May 2005 update of their paper entitled “Optimism and Economic Choice”, Manju Puri and David Robinson use data from the Survey of Consumer Finances (conducted every three years since 1989) to investigate the economic decisions of optimists, including financial portfolio construction. Defining optimism based on the mismatches between the life expectancies estimated by respondents for themselves and those indicated independently by actuarial tables (optimists expect to live longer than indicated actuarially), they find that: Keep Reading

Use the “Cone of Silence” When Buying Stocks?

In the June 2005 update of their paper entitled “All that Glitters: The Effect of Attention and News on the Buying Behavior of Individual and Institutional Investors”, Brad Barber and Terrance Odean examine the behaviors of individuals and institutions regarding attention-grabbing stocks. Using four datasets spanning 1991-1999 and focus on three measures associated with attention grabbing events (news, unusual trading volume and extreme returns), they find that: Keep Reading

Pricing Corporate News

In their May 2005 draft paper entitled “The Market Impact of Corporate News Stories”, Werner Antweiler and Murray Frank apply computational linguistics to 245,429 Wall Street Journal news stories published during 1973 to 2001 to examine how, and how quickly, stock prices fully reflect 43 different kinds of news. They find that: Keep Reading

Detecting Wisdom in a Crowded Market

In The Wisdom of Crowds: Why the Many Are Smarter Than the Few and How Collective Wisdom Shapes Business, Economies, Societies and Nations, James Surowiecki identifies and discusses the three conditions necessary for a crowd to make good group decisions. Applied to the stock market, good decisions means stock prices that reflect the true values of underlying assets. As depicted in the figure below, the three conditions are: Keep Reading

The Animal Spirits of Day-Trading

In the March 2005 update of their paper entitled “Fear and Greed in Financial Markets: A Clinical Study of Day-Traders”, Andrew Lo, Dmitry Repin and Brett Steenbarger examine possible links between psychological factors and trading performance in a sample of 80 day-traders recruited from a five-week on-line training program offered by Linda Bradford Raschke. Interaction with study participants occurred via anonymous email and online questionnaires. The authors find that: Keep Reading

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