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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.

A Few Notes on The Little Book of Behavioral Investing

In his 2010 book entitled The Little Book of Behavioral Investing: How Not to Be Your Own Worst Enemy, author James Montier states: “I…highlight some of the most destructive behavioral biases and common mental mistakes that I’ve seen professional investors make. I’ll teach you how to recognize these mental pitfalls while exploring the underlying psychology behind the mistake. Then I show you what you can do to try to protect your portfolio from their damaging influence on your returns.” Biases he surveys include: action bias, bias for stories, confirmation bias, conformity bias (herding or groupthink), conservatism (including sunk cost fallacy), disposition effect, empathy gap, endowment effect, hindsight bias, illusion of control, inattentional blindness, information overload, loss aversion, myopia, overconfidence, overoptimism, placebo effect, self-attribution bias and self-serving bias). Value investing provides the context for discussion. Citing a number of studies, he concludes that: Keep Reading

Individual Investor Trading Motivators

What makes individual investors trade more or less? In the March 2010 version of their paper entitled “Success/Failure of Past Trades and Trading Behavior of Investors”, Sankar De, Naveen Gondhi, Vishal Mangla and Bhimasankaram Pochiraju investigate how trading results affect future trading. Using detailed trading histories for 1.32 million individual Indian investors  involving 111 million transactions worth $85 billion in S&P CNX Nifty stocks during January 2006 through June 2006, they find that: Keep Reading

Deconstructing Effects of Corporate News

What types of corporate news have the most impact on stock price? In their February 2010 paper entitled “Market Reaction to Corporate News and the Influence of the Financial Crisis”, Andreas Neuhierl, Anna Scherbina and Bernd Schlusche analyze immediate stock return, volatility and liquidity reactions to various types of corporate news (focusing on one day before to five days after release date). They segment news releases into nine major categories and 52 subcategories. Using a comprehensive sample of 285,917 corporate press releases carried by all major news wire services between April 2006 and August 2009, they find that: Keep Reading

Individual Risk Tolerance Under the Hood

How can an advisor accurately gauge and effectively respond to the risk tolerance(s) of an advisee? In their January 2010 paper entitled “Beyond Risk Tolerance: Regret, Overconfidence, and Other Investor Propensities”, Carrie Pan and Meir Statman: (1) argue that the typical questionnaire used to assess advisee risk tolerance is deficient for five reasons; and, (2) offer remedies for these deficiencies. Using historical asset class return data and results of multiple investor surveys, they conclude that: Keep Reading

A Few Notes on Trading from Your Gut

In his 2009 book Trading from Your Gut: How to Use Right Brain Instinct & Left Brain Smarts to Become a Master Trader, author Curtis Faith uses stories and examples to “show how to develop your intuition and confidence in the decisions of your gut instinct so that you can use your whole mind while trading.” He preempts left-brained skeptics as follows: “If you are one of those traders who doesn’t believe that gut instinct or intuition has any place in trading, I invite you to keep an open mind. I, too, once felt as you did. After all, I was trained to take a very systematic and logical approach to trading… I believed that it was important to keep your emotions in check.” Some notable points from the book are: Keep Reading

Stock Price Clustering at Options Expiration

A reader commented: “Re ‘Clustering of Market Closes Near Round Numbers?’, the situation in which clustering is important is at option expiration on stocks with heavily traded options. Professional option writers maximize profit when the underlying stock closes near to the strike price at which the open interest is highest. Look at GOOG and how close it gets to a number divisible by $10 on that one day a month. The odds of closing exactly on such a number are 1/1000. Look at May 15: $390.00. Only the August expiration price for GOOG was not close to a ’10’ number.” Keep Reading

Clustering of Market Closes Near Round Numbers?

There is a fair amount of research on clustering of prices for individual stocks and other assets near round numbers. (For examples, search the Social Science Research Network for “price clustering”.) Do closing levels of the S&P 500 Index tend to cluster near round numbers? To investigate, we count the number of daily closes for adjacent 10-point ranges of the S&P 500 Index from one centered on 500 to one centered on 1570. The first range in the sample is therefore 495-505 and the last is 1565-1575. Using all closes of the index above 495 (roughly since 1995), we find that: Keep Reading

Abnormal Returns After Switches to/from Daylight Saving Time?

Do sleep disruptions from switches between standard time and daylight saving time reliably affect the return on the next trading day? In their September 2009 paper entitled “The Daylight Saving Time Anomaly in Stock Returns: Fact or Fiction?”, Russell Gregory-Allen, Ben Jacobsen and Wessel Marquering revisit this question based on a much larger sample than used in prior studies. Using daily returns of stock market indexes around switches to/from daylight saving time for 22 countries around the world spanning 1966-2005 (1,150 switches, tilted toward later decades), they conclude that: Keep Reading

Genetics of Investing (Not Algorithms)

Two recent papers investigate the genetics of individual investing. The September 2009 paper “Nature or Nurture: What Determines Investor Behavior?” by Amir Barnea, Henrik Cronqvist and Stephan Siegel examines the degree to which genetic makeup influences individual investing behavior. The July 2009 paper “IQ and Stock Market Participation” by Mark Grinblatt, Matti Keloharju and Juhani Linnainmaa explores the relationship between intelligence and individual investing. These studies conclude that: Keep Reading

Global Stock Market Contagion

A reader observed and asked: “In the last few weeks, there have been several times when the Dow Jones Industrial Average (DJIA) was down a lot, and Asian stock markets followed it down the next day. How reliably do Asian stock markets follow sharp drops in the U.S. stock market?” To investigate, we first examine the overall relationship between the U.S. stock market (represented, as suggested, by the DJIA) and Asian stock markets (Hang Seng and Nikkei 225). Then, we focus on what happens in Asian stock markets the day after sharp drops in the U.S. market. Using daily closing levels of the DJIA, the Hang Seng index and the Nikkei 225 index for 12/31/86-8/14/09 (roughly 5800 trading days), we find that: Keep Reading

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