Two Essays on Investor Attention and Asset Pricing

This dissertation explores the effect of investor attention, as measured by Google Search Volume Index, on security prices. It seeks to answer the following research questions: 1) what is the effect of investor attention on the expected returns of EREITs? And 2) what is the impact of investor attention on the open market repurchases post announcement returns? Classic theory suggests that information is immediately incorporated into stock prices. However, existing empirical evidence shows that investors are limited in terms of the amount of information they can process. Kahneman (1973) advances that attention is a scarce cognitive resource. Individuals suffer from bounded rationality. When faced with large amounts of information, they are limited in terms of how much they can process. This implies that prices may not reflect all available information due to limited investor attention. Essay 1 investigates the effect of investor attention on the expected returns of EREITs. The attention hypothesis of Barber and Odean (2008) suggests that increased attention leads to increased buying, which pushes prices and returns higher temporarily, but is followed by a reversal. We test the attention hypothesis on EREITs from 2004 to 2012 using Search Volume Index (SVI) data in Google Trends. We find that EREITs that generate high investor attention, as measured by SVI, earn higher returns compared to EREITs that generate no investor attention. The results are driven by small stocks and stocks with high book to market ratio. We report that the SVI effect is not due to impediments to trade and conjecture that SVI increases investor recognition among EREITs that are characterized by information incompleteness, leading to higher returns. Over time, this increase in returns is followed by a reversal. Essay 2 uses the attention hypothesis to generate insights into stock repurchases price drift. Using a sample of 318 firms that made repurchase announcements between 2004 and 2008 and which have weekly search volume data in Google Trends, we find that investor attention has an effect on the repurchase drift for stocks during the first year following the announcement. More specifically, high abnormal search volume leads to a positive effect on cumulative returns during the first year following the announcement for small stocks, stocks with high idiosyncratic risk, low market to book ratio, and low past return. Prior research has shown that for such stocks, the repurchase drift lasts for three years due to limits to arbitrage. As these stocks are dominated by retail investors, an increase in retail investors\u27 attention results in increased buying, which pushes prices and cumulative returns higher. Low abnormal search volume signals a decrease in investor attention and results in negative returns among all stocks. The results provide further support to the attention hypothesis. Both essays find evidence that the level of investor attention has an effect on security prices. This is contrary to the predictions of the classical theory that postulates that information is immediately incorporated into stock prices

Endogenous Correlation

We model endogenous correlation in asset returns via the role of heterogeneous expectations in investor types, and the dynamic impact of imitative learning by investors. Learning is driven by relative performance. In addition, we allow a cautious slow learning pace to reflect institutional conditions. Imitative learning shapes the market ecology that influences price formation. Using the model of non-imitative agents as a benchmark, our results show that the dynamics of imitative learning endogenously induce a significant degree of asset dependency and patterns of non-constant correlation. The asymmetric learning effect on correlation, however, implies a self-reinforcing process, where a bearish condition amplifies the effect that further exacerbates asset dependency. We conclude that imitative learning, even when rational, can to a certain extent account for the phenomena of market crashes. Our results have implications for transparency in regulation issues

Nonrational Actors and Financial Market Behavior

The insights of descriptive decision theorists and psychologists, we believe, have much to contribute to our understanding of financial market macrophenomena. We propose an analytic agenda that distinguishes those individual idiosyncrasies that prove consequential at the macro-level from those that are neutralized by market processes such as poaching. We discuss five behavioral traits - barn-door closing, expert/reliance effects, status quo bias, framing, and herding - that we employ in explaining financial flows. Patterns in flows to mutual funds, to new equities, across national boundaries, as well as movements in debt-equity ratios are shown to be consistent with deviations from rationality.

Irrationaalisten sijoittajien käyttäytymisen vaikutus arvopapereiden hintoihin

This thesis analyzes the effect that investors’ sentiment and overconfidence have on asset prices. Five interrelated essays examine the effect that the changes in U.S. small investor sentiment or the potential overconfidence of market participants in Nordic financial electricity market have on asset prices. The three first essays analyze the effect of changes in irrational investors’ sentiment on future U.S. equity market returns, both on the aggregate and cross-sectional level. The essays employ information from Google search volumes as a potential tool to gauge a new U.S. small investor sentiment. The first essay finds that increase in positive (negative) information retrieval in Google is associated with positive (negative) future returns on the S&P 500 index. The second and third essays find that positive (negative) unexpected changes in the new U.S. small investor sentiment predict not only positive (negative) future U.S. equity market returns, but also positive (negative) subsequent size and value premiums. The fourth and fifth essays examine the effect of investors’ potential overconfidence on option pricing in the Nordic financial electricity market. The fourth essay finds that the market participants are willing to overpay ex-ante for certain type of option contracts. The fifth essay also finds a seasonality effect in the ex-ante pricing of option con-tracts. Both, the investors’ willingness to overpay and the seasonality in the ex-ante pricing of option contracts, might suggest that the irrational investors are overconfident about the precision of their private information.Väitöskirjan viisi esseetä käsittelevät sijoittajien sentimentin sekä liiallisen itsevarmuuden vaikutusta arvopapereiden hintoihin. Tutkimuksissa analysoidaan amerikkalaisten piensijoittajien sentimentin muutosten tai Pohjoismaiden sähköpörssin markkinaosapuolien liiallisen itsevarmuuden potentiaalisia vaikutuksia arvopapereiden hintoihin. Ensimmäisessä kolmessa esseessä analysoidaan irrationaalisten sijoittajien sentimenttimuutosten yhteyttä Yhdysvaltojen osakemarkkinoiden tuleviin tuottoihin, hyödyntämällä informaatiota Google-hakusanoista. Ensimmäinen esseen tulokset osoittavat, että kasvu positiivisessa (negatiivisessa) tiedonhaussa ennakoi positiivisia (negatiivisia) odotettuja tuottoja S&P 500 -indeksille. Toisessa ja kolmannessa esseessä havaitaan, että positiivinen (negatiivinen) odottamaton muutos amerikkalaisten piensijoittajien sentimentissä ei ennakoi pelkästään osakemarkkinatuottoja Yhdysvalloissa, vaan niillä on myös positiivinen (negatiivinen) yhteys tuleviin koko- ja arvopreemioihin Yhdysvaltojen osakemarkkinoilla. Neljännessä ja viidennessä esseessä tutkitaan sijoittajien liiallisen itsevarmuuden potentiaalista vaikutusta Pohjoismaisen sähköpörssin hinnoitteluun. Neljännessä esseessä tulokset osoittavat, että sijoittajat ovat valmiita maksamaan ylihintaa tietynlaisista optioista. Viidennen esseen tulokset osoittavat lisäksi, että optioiden ylihinnoittelussa esiintyy myös kausivaihtelua. Tietynlaisten optioiden ylihinnoittelu sekä kausivaihtelu voivat viitata siihen, että sijoittajat ovat liian itsevarmoja heidän yksityisen informaationsa tarkkuudesta.fi=vertaisarvioitu|en=peerReviewed

Roots and Effects of Investments' Misperception

This work deals with the problem of investors' irrational behavior and financial products' misperception. The theoretical analysis of the mechanisms driving wrong evaluations of investment performances is explored. The study is supported by the application of Monte Carlo simulations to the remarkable case of structured financial products. Some motivations explaining the popularity among retail investors of these complex financial instruments are also provided. Investors are assumed to compare the performances of different projects through stochastic dominance rules and, to pursue our scopes, a new definition of this decision criteria is introduced.

Does Portfolio Optimization Pay?

All HARA-utility investors with the same exponent invest in a single risky fund and the risk-free asset. In a continuous time-model stock proportions are proportional to the inverse local relative risk aversion of the investor (1/γ-rule). This paper analyses the conditions under which the optimal buy and holdportfolio of a HARA-investor can be approximated by the optimal portfolio of an investor with some low level of constant relative risk aversion using the 1/γ-rule. It turns out that the approximation works very well in markets without approximate arbitrage opportunities. In markets with high equity premiums this approximation may be of low quality.HARA-utility, portfolio choice, certainty equivalent, approximated choice

Portfolio Choice for HARA Investors: When Does 1/γ (not) Work?

In the continuous time-Merton-model the instantaneous stock proportions are inversely proportional to the investorâs local relative risk aversion γ. This paper analyses the conditions under which a HARA-investor can use this 1/γ-rule to approximate her optimal portfolio in a finite time setting without material effects on the certainty equivalent of the portfolio payoff. The approximation is of high quality if approximate arbitrage opportunities do not exist and if the investorâs relative risk aversion is higher than that used for deriving the approximation portfolio. Otherwise, the approximation quality may be bad.HARA-utility, portfolio choice, certainty equivalent, approximated choice

Why does Implied Risk Aversion Smile?

A few recent papers have derived estimates of the representative agent's risk aversion by comparing the statistical density of asset returns and the state-price density. The implied risk aversion estimates obtained in these studies are puzzling, exhibiting (i) pronounced U-shaped patterns (a "smile") and (ii) negative values. This paper analyzes three potential explanations for these phenomena: (i) heterogeneity in investor preferences, (ii) difficulties in estimating agents' beliefs and (iii) heterogeneous beliefs among agents. Our results show that preferences alone cannot explain the patterns reported in the literature. Misestimation of investors' beliefs caused by nonstationarity of the return process cannot explain the smile either. The patterns of beliefs misestimation required to generate the empirical implied risk aversion estimates found in the literature suggest that heterogeneous beliefs are the most likely cause of the smile.asset pricing; state-price density; heterogeneous preferences; heterogeneous beliefs; implied risk aversion