Behavioral Economics Working Group

November 21, 2009
Andrea Frazzini and Kent D. Daniel, Organizers

Robin Greenwood, Harvard University and NBER; and Samuel Hanson, Harvard University
Catering to Characteristics

When investors overvalue a particular firm characteristic, corporations endowed with that characteristic can absorb some of the demand by issuing equity. Greenwood and Hanson use time-series variation in differences between the attributes of stock issuers and repurchasers to shed light on characteristic-related mispricing. During years when issuing firms are large relative to repurchasing firms, for example, large firms subsequently underperform. This holds true even when the authors restrict attention to the returns of firms that do not issue at all, suggesting that issuance is partly an attempt to cater to broad time-varying patterns in characteristics mispricing. Their approach helps forecast returns to portfolios based on book-tomarket (HML), size (SMB), price, distress, payout policy, profitability, and industry. These results are consistent with the view that firms play an important role as arbitrageurs in the stock market.

Mark Grinblatt, UC, Los Angeles; Matti Keloharju, Helsinki School of Economics; and Juhani Linnainmaa, University of Chicago
Do Smart Investors Outperform Dumb Investors?

Grinblatt, Keloharju, and Linnainmaa analyze whether high IQ investors exhibit superior investment performance. They combine equity return, trade, and limit order book data with two decades of scores from an intelligence test administered to nearly every Finnish male of draft age. Controlling for wealth, trading frequency, age, and determinants of the cross-section of stock returns on each day, they find that high IQ investors exhibit superior stock-picking skills, particularly for purchases, and superior trade execution for both purchases and sales.

Joseph Engelberg, University of North Carolina at Chapel Hill; and Christopher A. Parsons, University of North Carolina at Chapel Hill
The Causal Impact of Media in Financial Markets

It is challenging to disentangle the causal impact of media reporting from the impact of the events being reported. Engelberg and Parsons solve this problem by comparing the behaviors of investors with access to different media coverage of the same information event. They use zip codes to identify 19 mutually exclusive trading regions, corresponding to 19 large U.S. cities and local newspapers (for example, the Houston Chronicle). For all earnings announcements of S&P 500 Index firms, local media coverage strongly predicts local trading, after the authors control for characteristics of the earnings surprise, firm, local investors, and reporting newspaper(s). Moreover, the local trading-local coverage effect: 1) depends precisely on the specific timing of local reporting (that is, one day after the earnings announcement, two days afterward, and so on.) and 2) disappears entirely during extreme weather events, which leaves media content unchanged, but disrupts transmission to investors.

Malcolm Baker, Harvard Business School and NBER; Xin Pan, Harvard University; and Jeffrey Wurgler, NYU Stern School of Business and NBER
A Reference Point Theory of Mergers and Acquisitions

Baker, Wurgler, and Pan note that the use of judgmental anchors or reference points in valuing corporations affects several basic aspects of merger and acquisition activity including offer prices, deal success, market reaction, and merger waves. Offer prices are biased toward the 52-week high, a highly salient but largely irrelevant past price, and the modal offer price is exactly that reference price. An offer's probability of acceptance discontinuously increases when the offer exceeds the 52-week high; conversely, bidder shareholders react increasingly negatively as the offer price is pulled upward toward that price. Merger waves occur when high recent returns on the stock market and on likely targets make it easier for bidders to offer the 52-week high.

Victor Stango, UC, Davis; and Jonathan Zinman, Dartmouth College
Limited and Varying Consumer Attention: Evidence from Shocks to the Salience of Penalty Fees

Stango and Zinman study the impact of varying attention on the payment of bank account and credit card penalty fees. These fees are important profit centers for firms, are often shrouded from consumers at account opening, and are largely avoidable by consumers with small changes in behavior (meaning that inattention might plausibly explain why some people pay fees). The researchers measure fee payment using unusually rich, transaction-level, administrative data that spans multiple accounts, across multiple providers and months, for each consumer. Variation in attention comes from periodic surveys. Some surveys ask questions related to penalty fees, others do not. The questions do not provide information, and the survey topics are not pre-announced when the consumer chooses to take the survey. Conditional on selection into surveys, the authors find, penalty fee payment drops sharply immediately following a survey, but only if the survey contains a question on penalty fees. The reduction is short-lived when panelists have taken few relevant surveys, but long-lived when panelists have taken many relevant surveys. The results suggest that consumers have a stock of attention that periodic shocks can help to build or maintain; in contrast, one-shot upfront shocks such as disclosures at account opening may be ineffective or depreciate quickly.

Nicolae B. Garleanu, UC, Berkeley and NBER; and Lasse H. Pedersen, New York University and NBER
Margin-Based Asset Pricing and the Law of One Price

In a model with heterogeneous-risk-aversion agents facing margin constraints, Garleanu and Pedersen show how securities' required returns are characterized by their betas and their margins. Negative shocks to fundamentals make margin constraints bind, lowering risk-free rates and raising Sharpe ratios of risky securities, especially for high-margin securities. Such a funding liquidity crisis gives rise to "bases," that is, price gaps between securities with identical cash-flows but different margins. In the time series, bases depend on the shadow cost of capital, which can be captured through the interest rate spread between collateralized and uncollateralized loans. In the cross section, they depend on relative margins. The authors apply the model to CDS-bond bases and other deviations from the Law of One Price and use it to evaluate the Fed lending facilities.

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