NBER Reporter: Summer 2001

Behavioral Finance

The NBER's Working Group on Behavioral Finance, organized by Robert J. Shiller, NBER and Yale University, and Richard H. Thaler, NBER and University of Chicago, met in Chicago on May 25. The following papers were discussed:

Dilip J. Abreu and Markus K. Brunnermeier, Princeton University, "Bubbles and Crashes"

Discussant: Ming Huang, Stanford University

Shlomo Benartzi, University of California at Los Angeles, and Richard H. Thaler, "How Much is Investor Autonomy Worth?"

Discussant: Andrew Metrick, NBER and University of Pennsylvania

Randolph B. Cohen, Harvard University, and Paul A. Gompers and Tuomo O. Vuolteenaho, NBER and Harvard University,

"Who Underreacts to Cash-Flow News? Evidence from Trading Between Individuals and Institutions"

Discussant: Kent Womack, NBER and Dartmouth College

Kent D. Daniel, NBER and Northwestern University, and Sheridan Titman, NBER and University of Texas, "Market Reactions to Tangible and Intangible Information"

Discussant: Nicholas C. Barberis, NBER and University of Chicago

Jeffrey Pontiff, University of Washington, and Michael J. Schill, University of California at Riverside, "Long-Run Seasoned Equity Offering Returns: Data Snooping, Model Misspecification, or Mispricing? A Costly Arbitrage Approach"

Discussant: William N. Goetzmann, NBER and Yale University

Wesley S. Chan, MIT, "Stock Price Reactions to New and No-News Drift and Reversal After Headlines"

Discussant: Jay Ritter, University of Florida

Abreu and Brunnermeier present a model in which an asset bubble can persist despite the presence of rational arbitrageurs. The resilience of the bubble stems from the inability of arbitrageurs to coordinate their selling strategies temporarily. This synchronization problem, together with the individual incentive to time the market, results in the persistence of bubbles over a substantial period of time. The model provides a natural setting in which public events, by enabling synchronization, can have a disproportionate effect relative to their intrinsic informational content.

There is a worldwide trend towards increasing autonomy among investors; investors increasingly are able to pick their own portfolios. But how good a job are they doing? Bernartzi and Thaler present individuals who are saving for retirement with information about the distribution of outcomes they could expect from the portfolios they picked and also about the median portfolio selected by their peers. A majority of these survey participants actually prefer the median portfolio to the one they picked for themselves. Furthermore, a majority of investors who preferred to form their own portfolio rather than to accept one that was picked for them by a professional investment manager also preferred the distribution of returns implied by the suggested portfolio to the one they had selected on their own. The authors investigate various alternatives to these findings and offer some evidence to support the view that some of the results are attributable to the fact that investors do not have well-defined preferences.

A large body of literature suggests that firm-level stock prices "underreact" to news about future cash flows. Cohen, Gompers, and Vuolteenaho examine the joint behavior of returns, cash-flow news, and trading between individuals and institutions. They find that institutions buy shares from individuals in response to good cash-flow news, thus exploiting the underreaction phenomenon. Institutions are not simply following price momentum strategies: when price goes up in the absence of positive cash-flow news, institutions sell shares to individuals. The response of institutional ownership to cash-flow news is weaker for small stocks. Since small stocks also exhibit the strongest underreaction patterns, this finding is consistent with institutions facing exogenous constraints in trading small stocks.

Previous empirical studies suggest a negative relationship between fundamental performance over the past 3-5 years and future returns: distressed firms outperform more profitable firms. In fact, Daniel and Titman show that, after controlling for past stock returns, firms with higher past fundamental returns actually outperform weaker firms. These results are consistent with investors reacting appropriately to tangible information (that is, information that can be extracted from financial statements), but overreacting to intangible information. The authors explain these observations with a simple model based on the behavioral finding that investors are more overconfident about their ability to interpret intangible information than tangible information. Finally, Daniel and Titman reconcile their results with previous studies and show that firms which grow through share issuance experience low future returns, while firms that grow through increased profitability do not.

Pontiff and Schill use a new approach and assess the behavior of returns after seasoned equity offerings. They recognize that sophisticated investors are motivated to correct mispricing, although the magnitude of that activity is influenced by the costs of arbitrage. Their evidence supports the contention that firms that conduct seasoned equity offerings are overpriced. This implies that because mispricing associated with seasoned equity offerings is persistent in the long run, holding costs play an important role but transaction costs do not. In fact, holding costs dominate the size effect that is documented in earlier research.

Chan examines returns to a subset of stocks after public news about them is released. He compares them to other stocks with similar monthly returns, but no identifiable public news. There is a major difference between return patterns for the two sets. The evidence suggests post-news drift, which supports the idea that investors underreact to information. This underreaction is strongest after bad news. Chan also finds some evidence of reversal after extreme price movements unaccompanied by public news. The patterns exist even after Chan excludes earnings announcements, controls for potential risk exposure, and makes other adjustments. However, they appear to apply mainly to smaller stocks. Chan also finds that trading frictions, such as short-sale constraints, may play a role in the post-bad-news drift pattern.

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