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Psychology and Asset Prices

Paper Session

Saturday, Jan. 4, 2020 10:15 AM - 12:15 PM (PDT)

Manchester Grand Hyatt, Seaport G
Hosted By: American Finance Association
  • Chair: Camelia Kuhnen, University of North Carolina-Chapel Hill

"Superstitious" Investors

Hongye Guo
,
University of Pennsylvania
Jessica Wachter
,
University of Pennsylvania

Abstract

We consider an economy in which investors believe dividend growth is predictable,
when in reality it is not. We show that these beliefs lead to excess volatility and
return predictability. We also show that these beliefs are reasonable in the face of evidence on dividend growth. We apply this framework to explaining the value premium,
predictability of bond returns, and the violation of uncovered interest rate parity.

Prospect Theory and Stock Market Anomalies

Nicholas Barberis
,
Yale University
Lawrence Jin
,
California Institute of Technology
Baolian Wang
,
University of Florida

Abstract

We present a new model of asset prices in which investors evaluate risk according to prospect theory and examine its ability to explain 22 prominent stock market anomalies. The model incorporates all the elements of prospect theory, takes account of investors' prior gains and losses, and makes quantitative predictions about an asset's average return based on empirical estimates of its beta, volatility, skewness, and capital gain overhang. We find that the model is helpful for thinking about a majority of the anomalies we consider. It performs particularly well for the momentum, volatility, distress, and profitability anomalies, but poorly for the value anomaly. For several anomalies, the model explains not only the average returns of extreme anomaly deciles, but also more granular patterns in the average returns of intermediate deciles.

Price and Volume Dynamics in Bubbles

Jingchi Liao
,
Shenzhen Stock Exchange
Cameron Peng
,
London School of Economics

Abstract

We propose a model of “disposition extrapolators”—investors subject to both extrapolative beliefs and the disposition effect—to explain the sharp rise in both prices and volume observed in many financial bubbles. The model highlights a novel mechanism for volume, whereby disposition extrapolators are quick to buy a stock with positive past returns, but also quick to sell it if good returns continue. We test this model using account-level transaction data on the 2014–2015 Chinese stock market bubble and find that disposition extrapolators 1) sharply increase their volume, almost 300% more than pure extrapolators; 2) trade heavily on the extensive-margin; and 3) actively trade stocks they have never held before. Finally, we empirically show that extrapolators are responsible for driving up prices during the bubble.
Discussant(s)
Ian Dew-Becker
,
Northwestern University
Ian Martin
,
London School of Economics
Cary Frydman
,
University of Southern California
JEL Classifications
  • G1 - General Financial Markets