Behavioral Finance

March 24-25, 2017
Nicholas C. Barberis of Yale University, Organizer

Juhani T. Linnainmaa, University of South California, Marshall and NBER, and Michael R. Roberts, University of Pennsylvania and NBER

The History of the Cross Section of Returns (NBER Working Paper No. 22894)

Using data spanning the 20th century, Linnainmaa and Roberts show that most accounting-based return anomalies are spurious. When examined out-of-sample by moving either backward or forward in time, anomalies' average returns decrease, and volatilities and correlations with other anomalies increase. The data-snooping problem is so severe that even the true asset pricing model is expected to be rejected when tested using in-sample data. The researchers' results suggest that asset pricing models should be tested using out-of-sample data or, when not feasible, by whether a model is able to explain half of the in-sample alpha.

Robin Greenwood and Andrei Shleifer, Harvard University and NBER, and Yang You, Harvard University

Bubbles for Fama (NBER Working Paper No. 23191)

Greenwood, Shleifer, and You evaluate Eugene Fama's claim that stock prices do not exhibit price bubbles. Based on U.S. industry returns, 1926-2014, and international sector returns, 1986–2014, the researchers present four findings: (1) Fama is correct in that a sharp price increase of an industry portfolio does not, on average, predict unusually low returns going forward; (2) such sharp price increases do predict a substantially heightened probability of a crash; (3) attributes of the price run-up, including volatility, turnover, issuance, and the price path of the run-up can all help forecast an eventual crash; and (4) some of these characteristics can help investors earn superior returns by timing the bubble. Results hold similarly in U.S. and international samples.

Ming Dong, York University, and David Hirshleifer and Siew Hong Teoh, University of California at Irvine

Stock Market Overvaluation, Moon Shots, and Corporate Innovation

Dong, Hirshleifer, and Teoh test how market overvaluation affects corporate innovative activities and success. They find that estimated stock overvaluation is very strongly associated with R&D spending, innovative output, and measures of innovation originality, generality, and novelty. R&D spending is much more sensitive than capital investment to overvaluation. Although both channels operate, the effects of misvaluation on R&D spending come more from direct catering of firms to investor optimism than via equity issuance. The sensitivity of R&D and innovative output to misvaluation is greater among growth, overvalued, and high turnover firms. This evidence suggests that market overvaluation may have social value by increasing innovative output and by encouraging firm to engage in ambitious "moon shots."

Kent D. Daniel, Columbia University and NBER; Alexander Klos, Christian-Albrechts-Universität zu Kiel; and Simon Rottke, University of Muenster

Overpriced Winners

A strong increase in a firm's market price over the past year is generally associated with higher future abnormal returns, consistent with the momentum anomaly. However, for a small set of firms for which arbitrage is limited, high past returns forecast strongly negative future abnormal returns. Daniel, Klos, and Rottke propose a dynamic model in which increased unwarranted optimism by a set of speculators leads to dynamic mispricing effects. Consistent with this model, the researchers show a set of firms with high past returns, low institutional ownership, and high recent changes in short interest earns persistently low returns going forward. A strategy that goes short the overpriced winners and long other winners generates a Sharpe-ratio of 1.08; its returns cannot be explained by commonly used risk-factors.

Tobias J. Moskowitz, University of Chicago and NBER

Asset Pricing and Sports Betting

Two unique features of sports betting markets provide an informative laboratory to test behavioral theories of cross-sectional asset pricing anomalies: 1) the bets are idiosyncratic, having no systematic risk exposure; 2) the contracts have a known and short termination date where uncertainty is resolved that allows mispricing to be detected. Analyzing more than one hundred thousand contracts spanning almost three decades across four major professional sports (NBA, NFL, MLB, and NHL), Moskowitz finds strong evidence of momentum and weaker evidence of value effects that move prices from the open to the close of betting, which are then completely reversed by the game outcome. These findings are consistent with delayed overreaction theories of asset pricing, and are inconsistent with underreaction or rational pricing. In addition, a novel implication of overreaction uncovered in sports betting markets is shown to also predict returns in financial markets, where momentum is stronger and value is weaker when information is more uncertain. Despite evidence of mispricing, the magnitudes of momentum and value effects in sports betting markets are much smaller than those in financial markets, and are not large enough to overcome transactions costs, which prevent them from being arbitraged away.

Samuel M. Hartzmark, University of Chicago, and David H. Solomon, University of Southern California

The Dividend Disconnect

Hartzmark and Solomon show that many individual investors, mutual funds, and institutions trade as if dividends and capital gains are separate disconnected attributes, not fully appreciating that dividends come at the expense of price decreases. Behavioral trading patterns (e.g. the disposition effect) are driven by price changes excluding dividends. Investors treat dividends as a separate stable income stream, holding high dividend-yield stocks longer and displaying less sensitivity to their price changes. Demand for dividends is systematically higher in periods of low interest rates and poor market performance, leading to high valuations and lower future returns for dividend-paying stocks. Investors rarely reinvest dividends into the stocks from which they came, instead purchasing other stocks. This creates predictable marketwide price increases on days of large aggregate dividend payouts, concentrated in stocks not paying dividends.

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