Behavioral Finance Meeting

April 30, 2011
Stefano DellaVigna and Ulrike Malmendier, the University of California, Berkeley, Organizers

Robert F. Stambaugh, University of Pennsylvania and NBER; Jianfeng Yu, University of Minnesota; and Yu Yuan, University of Pennsylvania
The Short of It: Investor Sentiment and Anomalies

Stambaugh, Yu, and Yuan explore the role of investor sentiment in a broad set of anomalies in cross-sectional stock returns. They consider a setting where the presence of market-wide sentiment is combined with the argument that overpricing should be more prevalent than underpricing, because of short-sale impediments. Long-short strategies that exploit the anomalies exhibit profits consistent with this setting. First, each anomaly is stronger--its long-short strategy is more profitable--following high levels of sentiment. Second, the short leg of each strategy is more profitable following high sentiment. Finally, sentiment exhibits no relation to returns on the long legs of the strategies.

Annette Vissing-Jorgensen, Northwestern University and NBER
Consumer Credit: Learning Your Customer's Default Risk from What (S)he Buys

Using a novel panel data set covering half a million customers of a large Mexican retail chain, Vissing-Jorgensen studies determinants of consumer credit default. She documents that information about which products a customer buys provides substantial information about potential default losses on a given loan. Differences in default losses across product categories are robust to controlling for characteristics of the loan contract, demographics, and more standard measures of credit risk, and do not diminish substantially with how long the borrower has been a customer. The differential loss rates across product categories are driven mainly by which types of individuals buy particular products, as opposed to being product-specific features. High loss products tend to be luxuries and tend to be purchased by individuals who consume abnormally large fractions of luxuries given their income. She discusses how differences across consumers in their desire for indulgence or their degree of self-control may explain why loans to people who consume more luxuries incur higher loss rates. She proposes that providers of consumer credit could benefit from adjusting credit terms (down-payment requirements, interest rates, or credit limits) as a function of product mix purchased to date, and thus that product mix should be an important component of credit scoring.

Aydogan Alti, University of Texas, and Paul C. Tetlock, Columbia University
How Important Is Mispricing?

There is much controversy over whether risk or mispricing explains observed differences in firms' average stock returns. Alti and Tetlock contribute to this debate by proposing a quantitative model in which investors' information processing biases cause differences in firms' returns. The model matches many features of empirical data on firm production and asset pricing. They estimate the extent of biases that would reproduce empirical asset pricing anomalies and explore the implications of these biases. Their findings indicate that the magnitude of mispricing is several times larger than observed anomalies suggest. The model also provides novel insights into when and how information processing biases can cause substantial capital misallocation.

Sendhil Mullainathan, Harvard University and NBER; Markus Noeth, Hamburg University; and Antoinette Schoar, MIT and NBER
The Market for Financial Advice: An Audit Study

A growing literature shows that households are prone to behavioral biases in choosing portfolios. Yet a large market for advice exists which can potentially insulate households from these biases. Advisers may efficiently mitigate these biases, especially given the competition between them. But advisers' self interest -- and individuals' insufficiently correcting for it -- may also lead to them giving faulty advice. Mullainathan, Noeth, and Schoar use an audit study methodology with four treatments to document the quality of the advice in the retail market. The results suggest that the advice market, if anything, likely exaggerates existing biases. Advisers encourage chasing returns, push for actively managed funds, and even actively push them on auditors who begin with a well-diversified low fee portfolio.

Matti Keloharju, Aalto University; Samuli Knupfer, London Business School; and Juhani Linnainmaa, University of Chicago
From Customers to Shareholders: The Effect of Product Market Choices on Investment Decisions

Keloharju, Knupfer, and Linnainmaa show that individuals' product market choices influence their investment decisions. Using microdata from the brokerage and automotive industries, they find a strong positive relation between customer relationship, ownership of a company, and size of the ownership stake. Investors also are more likely to purchase and less likely to sell shares of companies they frequent as customers. These effects are stronger for individuals with longer customer relationships. A merger-based natural experiment confirms the main findings. A setup in which customer-investors regard stocks as consumption goods, not just as investment goods, seems to best explain these results.

Philipp Krueger, University of Geneva; Augustin Landier, Toulouse School of Economics; and David Thesmar, HEC Paris
The WACC Fallacy: The Real Effects of Using a Unique Discount Rate

Krueger, Landier, and Thesmar document investment distortions induced by the use of a single discount rate within firms. According to textbook capital budgeting, firms should value any project using a discount rate determined by the risk characteristics of the project. The authors directly test this consequence of the "WACC fallacy"and establish a robust and significant positive relationship between division-level investment and the spread between the division's market beta and the firm's core industry beta. Consistent with bounded rationality theories, this bias is stronger when the measured cost of taking the wrong discount rate is low, for instance, when the division is small. Finally, they measure the value loss due to the WACC fallacy in the context of acquisitions. Bidder abnormal returns are higher in diversifying mergers and acquisitions in which the bidder's beta exceeds that of the target. On average, the present value loss is about 0.7 percent of the bidder's market equity.

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