Bondt, Werner F.M. de

Palm, Franz C.

Wolff, Christian C.P.

English

Research Papers in Economics

Editorial
Introduction to the special issue
on behavioral finance
Twenty years ago, theoretical and empirical research in finance proceeded as if the
human factor in financial decision making did not matter very much. Many financial
economists admitted that the intuitive judgment of investors and their advisors revealed
some shortcomings, but they also maintained that the forces of rational arbitrage ensured
that market prices were efficient, i.e., stock prices quickly and adequately reflected all
available information. The psychology of money was seen as a captivating topic (surely,
for psychologists) but one that may well be ‘‘too interesting‘‘ for economists and that may
distract them ‘‘from the pervasive market forces that should be [their] principal concern’’
(Miller, 1986, p. 283).
Today, this point of view is less widespread and it has become less plausible. One
reason has to do with the extraordinary events of the 1980s and the 1990s (consider, e.g.,
the 1987 crash or the Nasdaq bubble). A second reason is that a new approach has
emerged. Behavioral finance thinks about financial issues with the help of ideas borrowed
from psychology. It not only casts doubt on the predictions of modern finance, such as the
notion of efficient markets, but also on its micro-foundations, i.e., expected utility
maximization, rational expectations and Bayesian updating. Prospect theory, mental
frames, heuristics and related psychological concepts form the basis for a new theory of
finance. Opinions differ, but so far, it appears, behavioral finance has been a fertile
paradigm. In the area of asset pricing, for instance, it has been used to interpret and/or to
discover empirical anomalies in the speculative dynamics of stock returns, e.g., under- and
overreaction to news. Additionally, through detailed surveys and archival studies of
trading behavior, a great deal has been learned about the conduct of investors, analysts,
money managers and others. In corporate finance, the behavioral approach has stimulated
interest in the determinants and the quality of executive decision making, e.g., excessive
risk aversion, unjustified optimism, hubris and so on (Kahneman, 2002).
In October 2002, the Journal of Empirical Finance and the Limburg Institute for
Financial Economics (LIFE) at the University of Maastricht jointly organized a conference
on behavioral finance in Palma de Mallorca (Spain). Methodologically, behavioral finance
operates at three levels: (i) it conducts experiments with subjects under controlled
laboratory conditions; (ii) it studies real-world financial decisions made by individuals,
households, financial professionals and corporations; and (iii) it looks into the behavior of
financial markets. By design, all the papers presented at the conference dealt with topics in
empirical asset pricing, i.e., either the behavior of investors (or their advisors) or the
0927-5398/$ - see front matter D 2004 Elsevier B.V. All rights reserved.
doi:10.1016/j.jempfin.2004.05.001
www.elsevier.com/locate/econbase
Journal of Empirical Finance 11 (2004) 423–427behavior of equity markets. Of specific interest was the controversial question of
momentum in stock prices, asset classes, expert recommendations and related variables.
We received approximately 50 paper submissions. Seven of the eight manuscripts
published in this special issue of the Journal of Empirical Finance were discussed in
Palma de Mallorca. We thank the authors, the discussants, the referees, as well as Ms.
Yolanda Paulissen (the editorial assistant). In addition, we are grateful to Professor Louis
Chan (University of Illinois at Urbana-Champaign) and Professor Meir Statman (Univer-
sity of Santa Clara) for presenting overview discussions of the contemporary literature on,
respectively, momentum and the trading motives of individual investors.
The first four articles in the special issue look at different aspects of momentum
strategies. Bange and Miller (2004) study the recommended global portfolio allocations
among equity, bonds and cash and among six countries by a panel of investment houses
between 1982 and 1999. (The quarterly recommendations are available to the public at
minimal cost since they are published in The Economist.) Prior research has shown that
investment newsletters advocate the purchase of securities that have performed well in the
past (Jaffe and Mahoney, 1999) and that small individual investors buy and sell stocks as if
past price movements may be extrapolated into the future (Bange, 2000). Interestingly,
Bange and Miller find a similar pattern in the advice of the investment houses. The results
are consistent with momentum trading. Then again, it may be that the investment houses
see the advice first and foremost as a marketing opportunity.
Price momentum over 6-to 12-month horizons was observed in US data by, among
others, Jegadeesh and Titman (1993, 2001).
1 Later, Moskowitz and Grinblatt (1999)
claimed that industry effects could account for much of the phenomenon. Nijman et al.
(2004) ask whether equity price momentum in Europe has significant country and industry
components. The short answer is no. Nijman et al. use monthly return data for 15 countries
and 23 industries between 1990 and 2000. They introduce an innovative portfolio-based
regression approach that has practical use to quantitative money managers. The chief
substantive finding of Nijman et al. is that an investor who does not wish to take large
country or industry bets may still be able to benefit from price momentum.
Chen and De Bondt (2004) suggest that investors can gain from equity style
management. Their research is motivated in part by the pervasive use of the value/growth
and small-cap/large-cap labels. Chen and De Bondt study all firms in the Standard and
Poor’s-500 index (1976–2000). Three characteristics (market value of equity, book-to-
market ratio and dividend yield) capture style-related trends in equity returns. Strategies
that buy stocks with characteristics that are currently in favor (past winners) and that sell
stocks with characteristics that are out of favor (past losers) perform well. Chen and De
Bondt believe that style momentum is distinct from price and industry momentum. They
offer evidence that the profitability of style momentum may be linked to changes in
macro-economic and financial conditions. However, the fact that many investors trade
1 Analogous findings were reported by De Bondt and Thaler (1985, Table 1 and Fig. 2). However, De Bondt
and Thaler did not emphasize momentum because they were more interested in 2- to 5-year price reversals which
they attributed to investor overreaction.
Editorial 424baskets of stocks—always chasing past winner styles and dumping losers—also seems a
likely cause of style momentum.
The fourth and final paper on momentum is co-authored by Karolyi and Kho (2004).
They devise a new test methodology—an estimation-based bootstrap simulation—to
evaluate what fraction of price momentum profits may be explained by cross-sectional
differences and time variation in expected returns, consistent with conventional asset
pricing models and efficient markets. Karolyi and Kho consider a variety of return-
generating models (as well as different sampling techniques in the bootstrap simulations),
but none of them is able to generate profits as large as the actual profits from a Jegadeesh–
Titman price momentum strategy. Yet, selected models yield simulated profits that are a
sizeable fraction of actual profits.
The next two papers in the special issue take up the well-known problem whether
equity returns are predictable from their past history. This matter has been the focal point
of a great deal of past research. Gropp (2004) uses a panel data approach to examine mean
reversion in industry portfolios for the United States over the period 1926–1998. Some
past tests that use traditional time-series methods have found litte evidence of mean
reversion. However, Gropp’s panel approach suggests that after temporary shocks,
industry portfolios revert halfway toward their fundamental levels over 4–8 years. These
results, Gropp shows, can form the basis for a successful contrarian investment strategy.
Patro and Wu (2004) use variance ratio tests to examine the predictability of daily,
weekly and monthly equity index returns for 18 industrialized countries over the period
1979–1998. Their contribution adds to the literature in several ways. For example, the
paper evaluates prior work by French and Roll (1986), Chan et al. (2000) and others. It is
found that over short horizons, equity indices in most (but certainly not all) countries show
signs of return continuation and that a winner–loser momentum arbitrage strategy may be
profitable. However, Patro and Wu emphasize that the findings must be interpreted with
caution. For instance, some tests yield different results depending on whether the indices
are expressed in local currency or in US dollars.
The final two papers of the special issue examine the specifically psychological
mechanisms that influence the speculative dynamics of stock prices. In theory, there are
three groups of (not mutually exclusive) behavioral causes for trends and reversals: (i)
biased forecasts of future profit potential; (ii) biased forecasts of risk and/or risk attitudes
that are in conflict with expected utility theory; and (iii) non-rational trading behavior that
reflects (falsely imagined) technical patterns in prices, superstition, emotion, or fashion,
and that is not linked to forecasts of business fundamentals in any way. The article by El-
Galfy and Forbes (2004) belongs to the first category while the article by Hwang and
Salmon (2004) belongs to the third.
Hwang and Salmon develop a new method to measure herding behavior by investors.
They define herding as imitation and suppression (or absence) of private information.
Hwang and Salmon investigate how the cross-sectional variation in factor sensitivities
(e.g., in capital asset pricing model betas) evolves over time. The idea is to quantify
deviations from equilibrium beliefs expressed in market prices. For instance, when
investors herd around the market consensus, the cross-sectional variance of stock betas
is expected to fall. Hwang and Salmon study the US and Korean stock markets between
1993 and 2002. They identify the Asian crisis and the Russian default as critical turning
Editorial 425points in herding behavior. It is striking that herding goes down and that market efficiency
improves during periods of market stress (see also Burstein, 1999).
The last paper, by El-Galfy and Forbes, reexamines the worthy question whether
financial analyst forecasts of corporate profits are rational. Seasoned market observers
(and, we should note, securities markets regulators) often hold false earnings expectations
responsible for price bubbles. Over the years, numerous studies have documented
excessive optimism (‘‘hype’’) as well as other biases in analyst predictions. However,
the prominent work of Keane and Runkle (1998) disputes these findings. El-Galfy and
Forbes inspect the key assumptions in Keane and Runkle’s modelling strategy, and they
extend the research in multiple ways. The revised estimates for the United States (1983–
1997) unmistakably show that analyst earnings forecasts are not rational with respect to
publicly available information.
Finally, the editors of the special issue have the pleasure to announce that Mary M.
Bange and Thomas W. Miller are the recipients of the Best Paper Award for their paper
entitled ‘‘Return Momentum and Global Portfolio Allocations’’.
References
Bange, M.M., 2000. Do the portfolios of small investors reflect positive feedback trading? Journal of Financial
and Quantitative Analysis 35, 239–254.
Bange, M.M., Miller, T.W., 2004. Return momentum and global portfolio allocations. Journal of Empirical
Finance 11 (4), 429–459. (doi:10.1016/j.jempfin.2004.02.002)
Burstein, G., 1999. Macrotrading and Investment Strategies: Macroeconomic Arbitrage in Global Markets.
Wiley, New York.
Chan, K., Hameed, A., Tong, W., 2000. Profitability of momentum strategies in international equity markets.
Journal of Financial and Quantitative Analysis 35, 153–172.
Chen, H.-L., De Bondt, W.F.M., 2004. Style momentum within the S&P-500 Index. Journal of Empirical
Finance 11 (4), 483–507. (doi:10.1016/j.jempfin.2004.04.005)
De Bondt, W.F.M., Thaler, R.H., 1985. Does the stock market overreact? Journal of Finance 40, 793–808.
El-Galfy, A.M., Forbes, W.P., 2004. Are forecasts of corporate profits rational? A note and further evidence.
Journal of Empirical Finance 11 (4), 617–626. doi:10.1016/j.jempfin.2004.04.004
French, K.R., Roll, R., 1986. Stock return variances: the arrival of information and the reaction of traders. Journal
of Financial Economics 17, 5–26.
Gropp, J., 2004. Mean reversion of industry stock returns in the U.S., 1926–1998. Journal of Empirical Finance
11 (4), 527–551. (doi:10.1016/j.jempfin.2004.04.002)
Hwang, S., Salmon, M., 2004. Market stress and herding. Journal of Empirical Finance 11 (4), 585–616.
(doi:10.1016/j.jempfin.2004.04.003)
Jaffe, J.F., Mahoney, J.M., 1999. The performance of investment newsletters. Journal of Financial Economics 53,
289–307.
Jegadeesh, N., Titman, S., 1993. Returns to buying winners and selling losers: implications for stock market
efficiency. Journal of Finance 48, 65–91.
Jegadeesh, N., Titman, S., 2001. Profitability of momentum strategies: an evaluation of alternative explanations.
Journal of Finance 56, 699–720.
Kahneman, D., 2002. Nobel Lecture. Stockholm, Sweden.
Karolyi, G.A., Kho, B.-C., 2004. Momentum strategies: some boodstrap tests. Journal of Empirical Finance
11 (4), 509–536. (doi:10.1016/j.jempfin.2004.02.004)
Keane, M.P., Runkle, D.E., 1998. Are financial analysts’ forecasts of corporate profits rational? Journal of
Political Economy 106, 768–805.
Miller, M.H., 1986. Behavioral rationality in finance: the case of dividends. Journal of Business 59, 267–284.
Editorial 426Moskowitz, T., Grinblatt, M., 1999. Do industries explain momentum? Journal of Finance 54, 1249–1290.
Nijman, T., Swinkels, L., Verbeek, M., 2004. Do countries or industries explain momentum in Europe? Journal of
Empirical Finance 11 (4), 461–481. (doi:10.1016/j.jempfin.2004.02.001)
Patro, D.K., Wu, Y., 2004. Predictability of short-horizon returns in international equity markets. Journal of
Empirical Finance 11 (4), 553–584. (doi:10.1016/j.jempfin.2004.02.003)
Werner De Bondt*
Driehaus Center for Behavioral Finance,
DePaul University, 1 E. Jackson Blvd.
Chicago, IL 60604, USA
E-mail address: wdebondt@depaul.edu
Franz PalmChristian Wolff
Maastricht University, Maastricht,
The Netherlands
* Corresponding author. Tel.: +1-312-362-8394; fax: +1-312-362-6566.
Editorial 427

Are forecasts of corporate profits rational? A note and further evidence.

Behavioral rationality in finance: the case of dividends.

Do countries or industries explain momentum in Europe?

Do industries explain momentum?

Do the portfolios of small investors reflect positive feedback trading?

Mean reversion of industry stock returns in the U.S.,

Momentum strategies: some boodstrap tests.

Nobel Lecture.

Profitability of momentum strategies in international equity markets.

Profitability of momentum strategies: an evaluation of alternative explanations.

Return momentum and global portfolio allocations.

Returns to buying winners and selling losers: implications for stock market efficiency.

Stock return variances: the arrival of information and the reaction of traders.

Style momentum within the S&P-500 Index.

Introduction to the special issue on behavioral finance.

http://arno.unimaas.nl/show.cgi?fid=10653

Introduction to the special issue on behavioral finance.

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