Behavioral Economics

Andrea Frazzini and Cliff Asness, AQR Capital Management, and Lasse Pedersen, Copenhagen Business School and NBER

Quality Minus Junk

Asness, Frazzini, and Pedersen define a quality security as one that has characteristics for which, all else equal, an investor should be willing to pay a higher price: stocks that are safe, profitable, growing, and well-managed. High quality stocks do have higher prices on average, but not by a very large margin. Perhaps because of this puzzlingly modest impact of quality on price, high quality stocks have high risk-adjusted returns. Indeed, a quality-minus-junk (QMJ) factor that goes long high quality stocks and shorts low quality stocks earns significant risk-adjusted returns in the United States and across 24 countries. The price of quality, that is, how much extra investors pay for higher quality stocks varies over time, reaching a low during the internet bubble. Further, a low price of quality predicts a high future return of QMJ. Finally, controlling for quality resurrects the otherwise moribund size effect.

Martin Cherkes and Charles Jones, Columbia University, and Chester Spatt, Carnegie Mellon University and NBER

A Solution to the Palm - 3Com Spin-off Puzzles

Cherkes, Spatt, and Jones revisit the relative pricing of Palm and 3Com shares in 2000. They offer a simple rational explanation of the Palm–3Com price relationship before Palm’s spin-off was completed. Lending fees and spin-off uncertainty are crucially important to understanding the relative levels and co-movement of Palm and 3Com share prices. The authors use Palm's post-spin-off forward prices (calculated from the market prices of calls and puts) and model the spin-off uncertainty in valuing 3Com. Considering forward pricing and spin-off uncertainty resolves various pricing puzzles and explains the observed empirical evidence, including a sharp change in relative price behavior once the spin-off uncertainty was resolved on May 8, 2000.

Chi Liao, University of Toronto

Risk Taking Begets Risk Taking: Evidence from Casino Openings and Investor Portfolios

Liao shows that individuals' non-investment risk-taking behavior can affect their willingness to take financial risks. Risk-taking itself is an activity that induces strong emotional responses. The author posits that the very act of taking risks may induce excitement, which Kuhnen and Knutson (2011) previously show can induce greater financial risk-taking. To test this hypothesis, she identifies a very specific setting where a subset of investors is more likely to be exposed to increased risk-taking through gambling. Using the initial legalization and opening of commercial casinos in the United States as a natural experiment, the author shows that the opening of a casino in close geographical proximity to investors results in increased risk-taking in the portfolios of those investors who are likely to visit the casino to gamble relative to those investors who are not. These likely gamblers, who are exposed to increased risk-taking, subsequently realize higher returns, but do not improve the overall mean-variance efficiency of their portfolios. These findings provide insight into the nature of risk-taking and the amplifying effect that taking risks in one context may have on financial risk-taking.

Francesco D'Acunto, University of California at Berkeley

Identity, Overconfidence and Investment Decisions

Why are men more risk-tolerant than women? Why do they invest more often and more aggresively than women? D’Acunto tests whether social identity can explain this heterogeneity. Identity prescribes normative behaviors to individuals. The author manipulates male and female identity in a controlled environment. In a set of four experiments, men whose identity is primed or threatened become more risk-tolerant, and they invest more often and more money than non-primed men and women. The effect of identity manipulations is largest for money-burning investment opportunities. The author relates male identity to overconfidence, which is induced in subjects by priming their sense of power over other individuals. Men induced to be overconfident also become more risk-tolerant and invest more often and more money than others. In a fifth experiment, the author finds that priming identity and overconfidence positively affects men's subjective beliefs about experiencing good investment outcomes.

Lauren Cohen and Christopher Malloy, Harvard University and NBER, and Dong Lou, London School of Economics

Playing Favorites: How Firms Prevent the Revelation of Bad News (NBER Working Paper 19429)

Cohen, Lou, and Malloy explore a subtle but important mechanism through which firms manipulate their information environments. They show that firms control the flow of information to the market through their specific organization and choreography of earnings conference calls. Firms that "cast" their conference calls by disproportionately calling on bullish analysts tend to underperform in the future. Firms that call on more favorable analysts experience more negative future earnings surprises and more future earnings restatements. A long-short portfolio that exploits this differential firm behavior earns abnormal returns of up to 101 basis points per month. Further, firms that cast their calls have higher accruals leading up to the call, barely exceed/meet earnings forecasts on the call that they cast, and in the quarter immediately following their casting tend to issue equity and have significantly more insider selling.

Bing Han, University of Texas, Austin, and David Hirshleifer, University of California, Irvine

Visibility Bias in the Transmission of Consumption Norms and Undersaving

Han and Hirshleifer study the spread of social norms for time preferences, and the effect of the transmission process on equilibrium consumption and discount rates. In the model, consumption is more salient than non-consumption. Because of visibility bias and the availability heuristic, people infer that low savings is normative and increase their own discount rates accordingly. This effect is self-reinforcing at the societal level, resulting in over-consumption and high interest rates. In contrast with Veblen effects, which imply greater wealth-signaling effects when there is greater information asymmetry about the wealth of others (as occurs with high wealth dispersion), in the authors' setting greater information asymmetry dilutes the inference from high observed consumption that the discount rate of others is high. In consequence, equilibrium consumption is lower, the opposite prediction.

Mark Kamstra, York University; Lisa Kramer, University of Toronto; Maurice Levi, University of British Columbia; and Russ Wermers, University of Maryland at College Park

Seasonal Asset Allocation: Evidence from Mutual Fund Flows

Over the past 30 years, mutual funds have become the dominant vehicle through which individual investors prepare for retirement via defined contribution plans. Further, money market mutual funds, which hold $2.7 trillion as of September 2013, are now a major part of the cash economy in the United States. Accordingly, the flow of money to and from different mutual fund categories (such as equities versus money funds) increasingly reflects the sentiment or risk aversion of the general population. In this study, Kamstra, Kramer, Levi, and Wermers analyze flows between different categories of mutual funds, and find strong evidence of a seasonality in risk aversion of individual investors. Specifically, they find that aggregate investor flow data reveals an investor preference for U.S. money market and government bond mutual funds in the autumn, and equity funds in the spring, controlling for the influence of seasonality in past performance, advertising, liquidity needs, and capital gains overhang on fund flows. This movement of large amounts of money between fund categories is correlated with a proxy for variation in investor risk aversion across the seasons, consistent with investors' revealed preferences for safer investments in the fall, and riskier investments in the spring. The authors find similar evidence in Canadian mutual fund flows, and in flows among Australian funds, where the seasons are six months out of phase relative to Canada and the United States. While prior evidence regarding the influence of seasonally changing risk aversion on financial markets relies on seasonal patterns in asset returns, the authors provide the first direct trade-related evidence.

Harrison Hong, Princeton University and NBER; Hyun-Soo Choi, Singapore Management University; Jeffrey Kubik, Syracuse University; and Jeffrey Thompson, Federal Reserve Board

When Real Estate is the Only Game in Town