Behavioral Finance

Samuel Hartzmark, University of Chicago, and Kelly Shue, University of Chicago and NBER

A Tough Act to Follow: Contrast Effects in Financial Markets

Hartzmark and Shue present evidence of contrast effects in financial markets: investors mistakenly perceive information in contrast to what preceded it, leading to significant distortions in market reactions to firm earnings announcements. Earnings news today seems more (less) impressive if yesterday's earnings surprise was bad (good). Consistent with contrast effects, the researchers find that the stock price reaction to an earnings announcement is negatively related to the earnings surprise announced by large firms in the previous day. In addition, 1) return reactions are inversely affected by earnings surprises released yesterday, but not by earnings released further in the past or the future, 2) a similar inverse relation exists for firms that release earnings sequentially within the same day, and 3) the mispricing reverses over the long run. The authors present a number of tests to show that their results cannot be explained by a key alternative explanation involving information transmission from the previous earnings announcement. Further, the results cannot be explained by strategic timing, changes in risk, or trading frictions.

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Sergey Chernenko, Ohio State University, and Samuel Hanson and Adi Sunderam, Harvard University and NBER

Who Neglects Risk? Investor Experience and the Credit Boom

Many have argued that overoptimistic thinking on the part of lenders helps fuel credit booms. Chernenko, Hanson, and Sunderam use new micro-data on mutual funds' holdings of securitizations to examine which investors are susceptible to such boom-time thinking. The researchers show that first-hand experience plays a key role in shaping investors' beliefs. During the 2003-2007 mortgage boom, inexperienced fund managers loaded up on securitizations linked to nonprime mortgages, accumulating twice the holdings of more seasoned managers by 2007. Moreover, inexperienced managers who personally experienced severe or recent adverse investment outcomes behaved more like seasoned managers. Training and institutional memory can serve as partial substitutes for personal experience.

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Nicholas Barberis; Robin Greenwood and Andrei Shleifer, Harvard University and NBER; and Lawrence Jin, California Institute of Technology

Extrapolation and Bubbles

Barberis, Greenwood, Jin, and Shleifer present an extrapolative model of bubbles. In the model, many investors form their demand for a risky asset by weighing two signals — an average of the asset's past price changes and the asset's degree of overvaluation. The two signals are in conflict, and investors "waver" over time in the relative weight they put on them. The model predicts that good news about fundamentals can trigger large price bubbles. The researchers analyze the patterns of cash-flow news that generate the largest bubbles, the reasons why bubbles collapse, and the frequency with which they occur. The model also predicts that bubbles will be accompanied by high trading volume, and that volume increases with past asset returns. The authors present empirical evidence that bears on some of the model's distinctive predictions.

Ian Gow, Harvard University; Steven Kaplan, University of Chicago and NBER; David Larcker, Stanford University; and Anastasia Zakolyukina, University of Chicago

CEO Personality and Firm Policies

Gow, Kaplan, Larcker, and Zakolyukina use linguistic features extracted from conferences calls and statistical learning techniques to develop a measure of CEO personality in terms of Big Five factors: Extraversion (versus Introversion), Emotional Stability (versus Neuroticism), Agreeableness, Conscientiousness, and Openness to Experience. The researchers find that their linguistic measures have strong out-of-sample classification performance and are stable over time, consistent with them measuring individual traits that are relatively persistent. They find that their measures of the Big Five personality factors are associated with organizational strategy choices, investment and financial policy, and firm performance.

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Umit Gurun, University of Texas, Dallas; Noah Stoffman, Indiana University; and Scott Yonker, Cornell University

Trust Busting: The Effect of Fraud on Investor Behavior

Gurun, Stoffman, and Yonker study the effects of trust on investor behavior and investment flows by exploiting the geographic dispersion of victims of a multi-billion dollar Ponzi scheme. Investors in communities that were more exposed to the fraud subsequently withdrew assets from investment advisers and increased cash deposits at banks. Exposed advisers were also more likely to close. Advisers who provide services that can build trust — such as financial planning — experienced much lower withdrawals. The evidence suggests that the trust shock was transmitted through social networks. Taken together, the authors' results show that trust is a critical determinant of asset allocation and has real economic effects.

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Sandra Black, University of Texas and NBER; Paul Devereux, University College Dublin; and Petter Lundborg and Kaveh Majlesi, Lund University

On the Origins of Risk-Taking in Financial Markets (NBER Working Paper No. 21332)

Risk-taking in financial markets is highly correlated between parents and their children; however, little is known about the extent to which these relationships are genetic or determined by environmental factors. Black, Devereux, Lundborg, and Majlesi use data on stock market participation of Swedish adoptees and relate this to the investment behavior of both their biological and adoptive parents. The researchers find that stock market participation of parents increases that of children by about 34% and that both pre-birth and post-birth factors are important. However, once they condition on having positive financial wealth, the authors find that nurture has a much stronger influence on risk-taking by children, and the evidence of a relationship between stock-holding of biological parents and their adoptive children becomes weaker. The researchers find similar results when they study the share of financial wealth that is invested in stocks. This suggests that a substantial proportion of the transmission of risk behavior from parents to children is environmentally determined.