Investor
Behaviors
*NEW*
Dumb money:
Mutual fund flows and the cross-section of stock returns, by Andrea Frazzini and
Owen Lamont, Working Paper #11526, National Bureau of Economic Research, 1050
Massachusetts Avenue, Cambridge, MA 02138, March 2005. This paper is
grim reading. Here is its overall conclusion: “[Mutual] Fund flows are dumb
money – by reallocating across different mutual funds, retail investors reduce
their wealth in the long run.”
The selection
and termination of investment management firms by plan sponsors, by Amit Goyal
and Sunil Wahal (this evidently unpublished manuscript was sent to me by a
friend in the investment world; the authors are both at Emory University in
Atlanta). This study of hiring and firing decisions by a broad sample
of 3700 plan sponsors over the years 1994 to 2003 is revealing and depressing.
Sponsors hire new managers showing large prior positive returns for up to three
years. But post-hiring returns are indistinguishable from zero. Managers
showing underperformance get fired, but then proceed to produce positive excess
returns afterward. If sponsors had stayed with fired managers, their excess
returns would have been larger than what they actually achieved.
Fear and
greed in financial markets: A clinical study of day-traders, by Andrew Lo,
Dmitry Repin, and Brett Steenbarger, Working Paper #11243, National Bureau of
Economic Research, 1050 Massachusetts Avenue, Cambridge, MA 02138, March 2005.
Using daily emotional-state surveys of 80 anonymous day traders, the authors
found that traders whose emotional reaction to monetary gains and losses was
more intense on both the positive and negative side. A standardized personality
inventory study survey did not real any specific “trader personality profile.”
The authors conclude that trading skills may not be innate and that different
personality types can trade equally well, but they will trade well only after
they are trained in self-control.
Why are
most funds open-end? Competition and the limits of arbitrage, by Jeremy Stein,
working Paper #10259, National Bureau of Economic Research, 1050 Massachusetts
Avenue, Cambridge, MA 02138, February 2004. This is a most important
paper. Stein argues that most funds are open-end and most investment
management contracts run for no more than one year before the client can quit.
Under these conditions, managers are hesitant to make long-run bets with the
risk of interim volatility that might cause withdrawals or quits because of
short-run volatility in results. But is it clients who insist on these
arrangements? Or is it managers with a zest for asset gathering, which would
be impossible in a closed-end framework. Read on — this is great stuff.
Aggregate
short interest and market valuations, by Owen Lamont and Jeremy Stein, Working
Paper #10218, National Bureau of Economic Research, 1050 Massachusetts Avenue,
Cambridge, MA 02138, January 2004. A major market myth says that
short sellers are so smart they are always selling against a trend. Another
myth says that short sellers accentuate falling markets and should be
restrained. This paper shows that the short interest moves in contracyclical
fashion, rising when the market falls and shrinking as it rises. Evidently,
arbitrageurs who use short selling are hesitant to bet against aggregate
mispricings, especially mispricings that tend to persist and move even further
from equilibrium values.
Local
does as local is: Information content of the geography of individual
investors’ common stock investments, by Zoran Ivkovich and Scott
Weisbenner, Working Paper #9685, May 2003, National Bureau of Economic
Research, 1050 Massachusetts Avenue, Cambridge, MA 02138.
From 1991 to 1996, households invested nearly a third of their portfolios
in firms located within a 250 mile radius of the investor’s home.
But information matters – these local investments outperform other
holdings in these investors’ portfolios, especially on stocks not
included in the S&P 500.
BUT SEE BELOW!
Thy
neighbor’s portfolio: Word-of-mouth effects in the holdings and trades
of money managers, by Harrison Hong, Jeffrey Kubik, and Jeremy Stein, Working
Paper 9711, National Bureau of Economic Research, 1050 Massachusetts Avenue,
Cambridge, MA 02138.
Don’t think that individual investors are the only ones where location matters.
Location, location, location seems to dominate investment in publicly-traded
companies as much as in real estate. This careful executed study shows that
mutual fund managers in the same city tend to buy the same stocks, even after
controlling for the local-preference effect that individual investors exhibit.
The authors describe this as an “epidemic model in which investors spread
information to one another by word of mouth.”
Clearly
irrational financial market behavior: evidence from the early exercise
of exchange traded stock options, by Allen
Poteshman and Vialy Serbin, The Journal of Finance, February 2003. This article reveals entirely different patterns of option exercise
by customers of brokerage houses and by proprietary traders at these
firms. The preponderance of customer exercises are “clearly irrational.” The
professionals are not. This evidence is important, not just for options
traders and investors, but also for students of market efficiency.
The evidence here is strongly in favor of behavioral finance.
Who
blinks in volatile markets, individuals or institutions? By Patrick
Dennis and Deon Strickland, Journal of Finance, October
2002. Answer: institutions, especially mutual funds and pension
funds, which are especially keen on herding. The paper arrives at this
conclusion
based on a detailed examination of stock returns on days when the absolute
value of the market’s return is large, upward or downward. The
paper provides important insights into the dynamics associated with
large swings in stock prices and the sources of market volatility.
“How
much is investor autonomy worth?” by
Shlomo Benartzi and Richard Thaler, The Journal of Finance, August
2002, studies the worldwide trend toward defined contribution savings
plans. The authors conducted an analysis of participants in the UCLA
plan and one other plan with a different setup. They then went directly
to the participants and asked them to choose from the portfolio the
participant had selected, the average of all the portfolios in the
group, and the median portfolio. In both instances, a majority opted
for the median portfolio over their own (even when selected by an outside
expert!). Further analysis and surveys conducted by the authors themselves
confirm that individuals, faced with difficult choices, resort to heuristics
like avoiding extremes. The authors conclude (1) that participants
should be given a limited number of choices and (2) that people tend
to select equal amounts of each option, which means the number of equity
options should be limited; otherwise, participants will load up on
equity positions. In short, defined contribution plans have many features
dangerous to the financial health of their participants.
