Behavioral Finance I

Paper Session

Saturday, Jan. 7, 2017 10:15 AM – 12:15 PM

Sheraton Grand Chicago, Chicago Ballroom IX
Hosted By: American Finance Association
  • Chair: Martin Schmalz, University of Michigan

Model Uncertainty, Ambiguity Aversion, and Market Participation

David Hirshleifer
,
University of California-Irvine
Chong Huang
,
University of California-Irvine
Siew Hong Teoh
,
University of California-Irvine

Abstract

Investor ambiguity aversion is a leading explanation for the puzzle of limited market participation. We show that a passive index fund that offers the `risk-adjusted market portfolio' induces full participation, reinstating the puzzle. In equilibrium, investors prefer to hold the fund and thus participate in all asset markets, even if they do not know the fund's composition. This results from a new portfolio information separation theorem which also applies in the absence of model uncertainty: every investor combines positions in a common, signal-independent exogenous risk-adjusted market portfolio, and a portfolio that depends upon the investor's private signals. In equilibrium, asset risk premia satisfy the CAPM with the fund as the pricing portfolio. We further show that these conclusions are robust to investor unawareness of some assets, and to heterogeneous risk tolerances even with extreme investor ignorance about the distribution of the risk tolerances. We conclude that limited participation may derive from other sources, such as imperfect investor understanding of the concept of market equilibrium.

A Tough Act to Follow: Contrast Effects in Financial Markets

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

Abstract

A contrast effect occurs when the value of a previously-observed signal inversely biases perception of the next signal. We present the first evidence that contrast effects can distort prices in sophisticated and liquid markets. Investors mistakenly perceive earnings news today as more impressive if yesterday’s earnings surprise was bad and less impressive if yesterday’s surprise was good. A unique advantage of our financial setting is that we can identify contrast effects as an error in perceptions rather than expectations. Finally, we show that our results cannot be explained by a key alternative explanation involving information transmission from previous earnings announcements.

Financial Loss Aversion Illusion

Christoph Merkle
,
University of Mannheim

Abstract

We test the proposition that investors' ability to cope with financial losses is much better than they expect. In a panel survey with real investors from a large UK bank, we ask for subjective ratings of anticipated returns and experienced returns. The time period covered by the panel (2008-2010), with frequent losses and gains in the portfolios of investors, provides the required background to analyze the involved hedonic experiences. We examine how the subjective ratings behave relative to expected portfolio returns and experienced portfolio returns. Loss aversion is strong for anticipated outcomes with investors reacting over twice as sensitive to negative expected returns as to positive expected returns. However, when evaluating experienced returns, the effect diminishes by more than half and is well below commonly found loss aversion coefficients. It seems that a large part of investors' financial loss aversion results from a projection bias.

Thinking about Prices versus Thinking about Returns in Financial Markets

Markus Glaser
,
University of Munich
Zwetelina Iliewa
,
Centre for European Economic Research
Martin Weber
,
University of Mannheim and Center for European Economic Research

Abstract

Prices and returns are alternative ways to present information and to elicit expectations in financial markets. But do investors make sense of prices and returns in the same way? This paper presents three studies with subjects of varying expertise, with various amounts of information and with different incentive schemes. The results are consistent across all studies: Asking subjects to forecast returns as opposed to prices results in higher expectations, whereas showing them return charts as opposed to price charts results in lower expectations. Experience is not a useful remedy but Cognitive Reflection mitigates the impact of format changes.
Discussant(s)
David Easley
,
Cornell University
John Beshears
,
Harvard University
Cary Frydman
,
University of Southern California
Markku Kaustia
,
Aalto University
JEL Classifications
  • G1 - Asset Markets and Pricing