Behavioral Finance

April 11, 2015
James Choi, Yale University, and Kelly Shue, University of Chicago, Organizers

Cary Frydman, University of Southern California

What Drives Peer Effects in Financial Decision-Making? Neural and Behavioral Evidence

Frydman uses neural data collected from an experimental asset market to test the underlying mechanisms that generate peer effects. In a sample of randomly assigned subjects who are given identical information, he finds strong causal peer effects in individual investment decisions. Frydman then uses the neural data to construct novel empirical tests that can distinguish between competing preference based explanations of peer effects. The observed neural activity is largely consistent with a preference for social status and relative wealth concerns. More generally, the neural data provide direct evidence that a change in relative wealth generates a utility shock that is distinct from a utility shock generated by a change in absolute wealth.

Hong Ru, MIT, and Antoinette Schoar, MIT and NBER

Do Credit Card Companies Screen for Behavioral Biases?

Ru and Schoar look at the supply side of the credit card market to analyze the pricing and advertising strategies of credit card offers. The researchers show that credit cards which have reward programs have lower regular APR but rely more heavily on backward loaded and more hidden payment features such as late fees, default APR or over limit fees. Issuers target different reward programs at different types of the population: Programs such as miles, cash back and points are offered to richer and more educated customers, while low intro APR offers are offered to poorer and less educated customers. The results support the idea put forward in models of behavioral contract theory that credit card companies use reward programs to either shroud aspects of a card offer or exploit their time inconsistency. The authors' results also suggest that card features that are mainly demanded by sophisticated consumers cannot be shrouded and need to be priced upfront. Finally, using shocks to the credit worthiness of customers via increases in state level unemployment insurance, the authors show that card issuers rely more heavily on backward loaded credit terms when customers are more protected.

Dong Lou and Christopher Polk, London School of Economics, and Spyros Skouras, Athens University of Economics and Business

A Tug of War: Overnight versus Intraday Expected Returns

Lou, Polk, and Skouras decompose the abnormal profits associated with well-known patterns in the cross-section of expected returns into their overnight and intraday components. The researchers show that, on average, all of the abnormal returns on momentum strategies remarkably occur overnight while the abnormal profits on the other trading strategies they consider occur intraday. These patterns are extremely robust across subsamples and indeed are stronger for large-cap and high-price stocks. Furthermore, the authors find that all of the variables that are anomalous with respect to the Fama-French-Carhart model have risk premiums overnight that partially offset their much larger intraday average returns. Indeed, a closer look reveals that in every case a positive risk premium is earned overnight for the side of the trade that might naturally be deemed as riskier. In fact, the authors show that an overnight CAPM explains much of the cross-sectional variation in average overnight returns they document. Finally, the researchers argue that investor heterogeneity may explain why momentum profits tend to accrue overnight. They first provide evidence that, relative to individuals, institutions prefer to trade during the day and against the momentum characteristic. They then highlight conditional patterns that reveal a striking tug of war. Either in the time series, when the amount of momentum activity is particularly low, or in the cross-section, when the typical institution holding a stock has a particularly strong need to rebalance, the authors find that momentum returns are even larger overnight and more strongly reverse during the day. Both cases generate variation in the spread between overnight and intraday returns on the order of 2 percent per month.

Erik Eyster, London School of Economics; Matthew Rabin, University of California, Berkeley; and Dimitri Vayanos, London School of Economics and NBER

Financial Markets where Traders Neglect the Informational Content of Prices

Eyster, Rabin, and Vayanos present a model of a financial market where some traders are "cursed" when choosing how much to invest in a risky asset, failing to take into account what prices convey about others' private information. In contrast to rational-expectations equilibrium (REE), the model predicts extensive trade, which can increase in the presence of more private information. The price responds more to public information and less to private information than in REE, causing momentum in asset returns. Also in contrast to REE, cursed traders with more precise private information can be worse off than traders with less precise information. The researchers contrast their results to other models of departures from REE and show that trading volume among cursed agents converges to infinity when the number of agents becomes large, while natural forms of overconfidence predict that volume should remain bounded.

Olivier Dessaint, University of Toronto, and Adrien Matray, HEC-Paris

Do Managers Overreact to Salient Risks? Evidence from Hurricane Strikes,

Consistent with salience theories of choice, Dessaint and Matry find that managers overreact to salient risks. The researchers study how managers respond to the occurrence of a hurricane event when their firms are located in the neighborhood of the disaster area. They find that the sudden shock to the perceived liquidity risk leads managers to increase the amount of corporate cash holdings, even though the real liquidity risk remains unchanged. Such an increase in cash holdings is only temporary. Over time, the perceived risk decreases, and the bias disappears. This bias is costly for shareholders because it leads to higher retained earnings and negatively impacts firm value by reducing the value of cash. The authors examine alternative explanations for their findings. In particular, they find only weak evidence that the possibility of risk learning or regional spillover effects may influence their results.

Joshua Madsen, University of Minnesota, and Marina Niessner, Yale University

Is Investor Attention for Sale? The Role of Advertising in Financial Markets

This paper identifies the effects of product market advertising on financial markets, and finds that managers strategically use advertising to influence investor attention. First, Madsen and Niessner document that print ads, especially in weekend business publications, cause an increase in Google searches for company tickers. The researchers further find that ads trigger downward pressure on prices of stocks with recent price increases, consistent with investors exhibiting a disposition effect. In the second part of the paper, the authors show that managers strategically increase advertising in the weeks around earnings announcements if the earnings surprise is positive, and that this increased advertising decreases the post-earnings announcement drift.

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