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Belief Formation and Economic Implications

Paper Session

Saturday, Jan. 4, 2025 10:15 AM - 12:15 PM (PST)

San Francisco Marriott Marquis, Yerba Buena Salon 8
Hosted By: American Finance Association
  • Yueran Ma, University of Chicago

Taking the Road Less Traveled? Market Misreaction and Firm Innovation Directions

Tianshu Lyu
,
Yale University
Zunda Winston Xu
,
Stanford University

Abstract

We propose that public investors react differently to patent issuance depending on its novelty, and these misreactions exert real impacts on the firms' future innovations. First, using textual analyses of patent documents to measure patent novelty, we find that investors underreact to the issuance of path-breaking innovations while overreact to the trend-following ones. Novel patent issuance predicts lower risk but positive forecast errors, consistent with a non-risk-based novelty mispricing mechanism. A bounded-rationality model, where investors cannot figure out the true novelty of a patent at issuance due to cognitive limits, explains the empirical patterns well. Second, using exogenous distraction shocks, such as sensational news, we present causal evidence that after disappointing returns, novel firms shift from creating and following up on novel innovations to copycatting. The findings highlight that investors' misreactions to patent novelty impact firms' future innovation directions by steering them away from higher-valued, groundbreaking research.

Finfluencers

Ali Kakhbod
,
University of California-Berkeley
Seyed Mohammad Kazempour
,
Rice University
Dmitry Livdan
,
University of California-Berkeley
Norman Schuerhoff
,
University of Lausanne

Abstract

Tweet-level data from a social media platform reveals high dispersion and systematic bias in the. quality of advice by financial influencers, or “finfluencers”: 28% of finfluencers are skilled, generating 2.6% monthly abnormal returns, 16% are unskilled, and 56% have negative skill (“antiskill”)
generating −2.3% monthly abnormal returns. Antiskilled finfluencers have more followers and more
influence on retail trading than skilled finfluencers. The advice by antiskilled finfluencers creates overly optimistic beliefs most times and persistent swings in followers’ beliefs. Consequently, finfluencers cause excessive trading and inefficient prices such that a contrarian strategy yields 1.2%
monthly out-of-sample performance.

Law of Small Numbers in Financial Markets: Theory and Evidence

Lawrence Jin
,
Cornell University
Cameron Peng
,
London School of Economics and Political Science

Abstract

We build a model of the law of small numbers (LSN)---the incorrect belief that even small samples represent the properties of the underlying population---to study its implications for trading behavior and asset prices. In the model, a belief in the LSN induces investors to expect short-term price trends to revert and long-term price trends to continue. As a result, asset prices exhibit excess volatility, short-term momentum, and long-term reversals. The model makes additional predictions about investor behavior, including the coexistence of the disposition effect and return extrapolation, a weakened disposition effect for long-term holdings, "doubling down"" in buying

Discussant(s)
Aakash Kalyani
,
Federal Reserve Bank of St. Louis
Runjing Lu
,
University of Toronto
Eben Lazarus
,
University of California-Berkeley
JEL Classifications
  • G1 - General Financial Markets