Behavioral Finance

The NBER's Working Group on Behavioral Finance met April 6-7 in Chicago. Working Group Director Nicholas C. Barberis of Yale University organized the meeting. These researchers' papers were presented and discussed:

Olivier Dessaint, University of Toronto; Clemens Otto, Singapore Management University; Jacques Olivier, HEC Paris; and David Thesmar, MIT

CAPM-Based Company (Mis)valuations

There is a discrepancy between CAPM-implied and realized returns. As a result, using the CAPM in capital budgeting decisions -- as is recommended in finance textbooks -- should have valuation effects. For instance, low beta projects are expected to be valued more by CAPM-using managers than by the market. Dessaint, Otto, Olivier, and Thesmar empirically test this hypothesis using publicly announced M&A decisions. They show that takeovers of lower beta targets are accompanied by lower CARs for the bidder. Consistent with the researchers' hypothesis, the effect is more pronounced for larger acquisitions, higher growth targets, and private targets. Furthermore, low beta bidders are more likely to use their own stock to finance the deal. More generally, low beta firms are less likely to issue equity, and more likely to repurchase shares. These effects are not reversed in the long-run, suggesting that CAPM-using managers may be irrational, though this last test lacks power.

Darrell Duffie, Stanford University and NBER, and Samuel Antill, Stanford University

Pedro Bordalo, University of Oxford; Nicola Gennaioli, Università Bocconi; Yueran Ma, Harvard University; and Andrei Shleifer, Harvard University and NBER

Overreaction in Macroeconomic Expectations

Bordalo, Gennaioli, Ma, and Shleifer examine the rationality of individual and consensus professional forecasts of macroeconomic and financial variables using the methodology of Coibion and Gorodnichenko (2015), which focuses on the predictability of forecast errors from earlier forecast revisions. They document two principal findings: forecasters typically over-react to information at the individual level, while consensus forecasts exhibit underreaction. To reconcile these findings, the researchers combine the diagnostic expectations model of belief formation from Bordalo, Gennaioli, and Shleifer (2018) with Woodford's (2003) noisy information model of belief aggregation. The model accounts for the findings, but also yields a number of new implications related to the forward looking nature of diagnostic expectations, which the researchers also test and confirm. Finally, they compare their model to mechanical extrapolation, rational inattention, and natural expectations.

Stephen Foerster, Western University; Juhani T. Linnainmaa, University of Southern California and NBER; Brian T. Melzer, Federal Reserve Bank of Chicago; and Alessandro Previtero, Indiana University and NBER

Financial Advisors and Risk-Taking

Foerster, Linnainmaa, Melzer, and Previtero show that financial advisers increase stock market participation and risk-taking. The researchers first exploit a regulatory change in Canada that restricted the supply of financial advisers in all provinces except Quebec. Their estimates suggest that having a financial adviser increases stock market participation and reduces investments in cash accounts. The researchers also use micro-level data on financial advisory accounts to document that the length of the adviser-client relationship -- a measure of trust -- increases clients' willingness to take financial risk. Using exogenous shocks to adviser-client pairings as an instrument for the relationship length, find that clients who started with a new adviser before the 2007-2009 financial crisis were less likely to remain invested in the stock market throughout the crisis.

Kent D. Daniel, Columbia University and NBER; Lorenzo Garlappi, University of British Columbia; and Kairong Xiao, Columbia University

Monetary Policy and Reaching for Income

Daniel, Garlappi, and Xiao study the impact of monetary policy on investors' portfolio choice and asset prices. Using data on mutual fund flows and individual trading records, they find that low-interest-rate monetary policy increases investors' demand for high-dividend stocks and drives up their asset prices. To explain these empirical findings, the researchers develop a portfolio choice model in which investors have quasi-hyperbolic time preferences and use dividend income as a commitment device to curb their tendency to over-consume in the short-run. When accommodative monetary policy lowers interest rates, it reduces the income stream from bonds and induces investors who are concerned about keeping a desired level of consumption to "reach for income'' by tilting their portfolio towards high-dividend stocks. Daniel, Garlappi, and Xiao's finding suggests that low-interest-rate monetary policy may lead to under-diversification of investors' portfolios and may cause redistributive effects across firms that differ in their dividend policy.

Kelly Shue, Yale University and NBER, and Richard Townsend, University of California, San Diego

Money Illusion in Asset Pricing

A form of "money illusion" in financial markets may cause investors to think that news should correspond to a dollar change in price rather than a percentage change in price, leading to return underreaction for high-priced stocks and overreaction for low-priced stocks. Consistent with a simple model of money illusion, Shue and Townsend find that total volatility, idiosyncratic volatility, and absolute market beta are significantly higher for stocks with low share prices or negative past returns. To identify a causal effect of price, they show that volatility increases sharply following stock splits and drops following reverse stock splits. The economic magnitudes are large: money illusion can explain a significant portion of the "leverage effect" puzzle, in which volatility is negatively related to past returns, as well as the volatility-size and beta-size relations in the data. The researchers also show that money illusion distorts investor reactions to news that is itself reported in nominal rather than real units. Investors react to nominal earnings per share surprises, after controlling for the earnings surprise scaled by price. The reaction to the nominal earnings surprise reverses in the long run, consistent with correction of mispricing.

James J. Choi, Yale University and NBER, and Adriana Z. Robertson, University of Toronto

What Matters to Individual Investors? Evidence from the Horse's Mouth

Choi and Robertson survey a representative sample of U.S. individuals about how well leading academic theories describe their financial beliefs and decisions. They find substantial support for many factors hypothesized to affect portfolio equity share, particularly background risk, investment horizon, rare disasters, transactional factors, and fixed costs of stock market participation. Individuals tend to believe that past mutual fund performance is a good signal of stock-picking skill, actively managed funds do not suffer from diseconomies of scale, value stocks are safer and do not have higher expected returns, and high-momentum stocks are riskier and do have higher expected returns.

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