Arun J. Prakash

Portfolio selection and skewness: Evidence from international stock markets

Abstract This paper finds that the returns of the worlds 14 major stock markets are not normally distributed, and that the correlation matrix of these stock markets was stable during the January 1988–December 1993 time period. Polynomial goal programming, in which investor preferences for skewness can be incorporated, is utilized to determine the optimal portfolio consisting of the choices of 14 international stock indexes. The empirical findings suggest that the incorporation of skewness into an investors portfolio decision causes a major change in the construction of the optimal portfolio. The evidence also indicate that investors trade expected return of the portfolio for skewness.

Selecting a Portfolio with Skewness: Recent Evidence from US, European, and Latin American Equity Markets

Polynomial goal programming, in which investor preferences for skewness can be incorporated, is utilized to determine the optimal portfolio from Latin American, US and European capital markets.The empirical findings suggest that the incorporation of skewness into an investors portfolio decision causes a major change in the resultant optimal portfolio. The empirical evidence indicates that investors do trade expected return of the portfolio for skewness.

Bank mergers and components of risk: An evaluation

The present study empirically examines the contribution of the acquired banks in only the nonconglomerate types of mergers (i.e., banks with banks), where the bulk of the payment is in the form of equity to the acquiring bank and finds overwhelmingly statistically significant evidence that nonconglomerate types of mergers definitely reduce the total as well as the unsystematic risk while having no statistically significant effect on systematic risk. Therefore, it seems that diversification may be a possible motive for bank mergers.

Answering Financial Anomalies: Sentiment-Based Stock Pricing

The efficient market hypothesis (EMH) assumes that investors are rational and value securities rationally. A rational investor would value a security by its net present value; the price of a stock in this framework is based on the discounted cash flow or the present value model. Although the EMH-based model is partially successful in computing fundamental stock prices, other anomalies such as high trading volume, high volatility, and stock market bubbles remain unexplained. These models assume rational investors who are utility maximizers. But some investors behave irrationally or against the predictions, and in the aggregate they become irrelevant. In this paper, we relax the assumption of investor rationality, and attempt to explain high volatility, high trading volume, and stock market bubbles by incorporating investor sentiment into the already existing asset pricing model.

Marginal risk aversion and preferences in a betting market

An individuals behavioural attitudes toward variance and non-symmetry in the payoff distributions of pari-mutuel gambles are empirically examined using the von Neumann - Morgenstern expected utility of wealth paradigm. Preferences over payoff distributions for a representative bettor are estimated from observed payoffs at a greyhound racetrack. The results indicate that the representative bettor exhibits increasing absolute risk aversion and, given that the representative bettor is locally non-satiated with regard to wealth, exhibits preference for variance and aversion to positive skewness in the payoff distributions of the gambles examined.

Asset pricing models: a comparison

We empirically test and compare the performance of the traditional capital asset pricing model (CAPM), the three-moment CAPM and the Fama–French (FF) three-factor model using the FF 25 portfolios data. Based on the time-series and the cross-sectional tests, the FF three-factor model outperforms the other models. In the cross-sectional tests, the three-moment CAPM has a higher R 2 than CAPM but in the time-series regression, the performances of CAPM and the three-moment CAPM are comparable.

Can Diversification be Learned

We investigate the role of financial education in household portfolio allocation decisions using data from a survey of 1,382 professors at universities across the United States. The results suggest that knowledge of diversification increases the likelihood that investors will efficiently allocate their investments across the major asset classes as well as invest in foreign assets. However, we find that investors with advanced knowledge of finance still tend to hold undiversified equity portfolios.

Skewness preference and the measurement of abnormal returns

In performing an empirical analysis of stock market returns there are certain conditions under which the quadratic characteristic line (QCL) will be the appropriate return-generating process compared to the linear characteristic line (LCL). These conditions are whether the parameter associated with the squared market term (the deviation from the mean) is significantly different from zero and whether the return on the market portfolio is asymmetrically distributed (or skewness is present). Examining abnormal returns surrounding stock splits, we find that these conditions hold for our data set. Having ascertained that the conditions for QCL hold, we find that the cumulative average returns (CARs) obtained using QCL dominate the CARs obtained using LCL in the event time and the CAR space for the dividend-increase sub-sample. Furthermore, the standardized abnormal returns for the QCL model are significantly different than those obtained using the LCL model. We find that neither the LCL nor the QCL paradigm reveals any statistically significant abnormal return for the dividend-decrease group. However, for the dividend-decrease group, the CARs for the LCL model dominate the CARs for the QCL model. The standardized abnormal returns for the QCL model are also significantly different than those of the LCL model. Using QCL, we find support for the signalling hypothesis of dividends. We also find that the extent of investor reaction obtained using QCL is statistically significantly different than that obtained using the LCL.

The Role of Financial Education in the Management of Retirement Savings

We investigate the role of financial education in the management of Defined Contribution retirement savings plans. We survey Finance and English professors from universities across the United States and compare the management of their savings in the TIAA-CREF® plans. We find that compared with English professors, Finance professors allocate a larger share of their retirement savings to equities, they manage their retirement portfolios more actively, and they are less likely to practice naïve diversification strategies.

Do Finance Professors Invest Like Everyone Else

Comparing the results of the Fed’s Survey of Consumer Finances with those of a survey of finance professors at U.S. universities, the authors found that finance professors are significantly more likely than others to invest in equities. They also found that finance professors are less prone to behavioral biases because their decision not to invest in equities is based on neither the outcome of their past investments nor their short-term expectations of the market. See comments and response on this article. Standard rational economic models predict that in the presence of a positive risk premium, all investors will hold some equity. However, there is evidence in the finance literature that a number of households in the United States hold no equity. Results from the Fed’s Survey of Consumer Finances (SCF) show that even within the top quintile of income distribution, a significant number of households do not invest in equities. In our study, we examined the investment pattern of finance professors to investigate whether they participate in the stock market to a greater extent than the general public. Finance theory suggests that in order to achieve optimal diversification, a portion of every portfolio should be invested in equities. Because finance professors are advocates of traditional finance theory on equity market participation, we would expect all finance professors to invest in equities. To test whether this group of experts practices what it preaches, we surveyed finance professors at universities across the United States. During the summer of 2007, using the University of Texas at Austin list of all regionally accredited universities, we manually collected the names and e-mail addresses of finance professors at these institutions. We used a questionnaire to collect data on actual portfolio holdings and demographics from each finance professor selected. We investigated whether finance professors, compared with households in the Fed’s 2007 SCF sample, are significantly more likely to invest in equities. Because our investigation focused on individuals who provided detailed information on their financial asset holdings, we included 4,160 respondents from the SCF sample and 1,368 respondents from the finance faculty sample. Unsurprisingly, we found that finance professors participate in the stock market to a greater extent than do members of the SCF sample. However, our counterintuitive finding is that a significant number of the finance professors do not participate in the stock market. Arguably, those finance professors who choose not to hold stocks are aware of the “rational” arguments for investing in stocks. Our findings thus raise the question of whether it is an oversimplification to suggest that not holding stocks is an investment “mistake.” Therefore, advising those less knowledgeable in finance always to hold stocks may not be beneficial. We also investigated whether some behavioral biases related to nonparticipation in the stock market are present in our sample of finance professors. Researchers have broadly characterized these biases as overconfidence and considering the past. An investor’s overconfidence in the future prospects of an investment can lead to an increased affinity for risk taking. With respect to the bias of considering the past, two alternative manifestations have been popularized: (1) Investors are willing to take on more risk after experiencing a gain because they believe they are using the house’s money, and (2) investors are willing to take on more risk after experiencing a loss because they are trying to recoup their prior losses (i.e., break even). We first examined whether finance professors are so confident in their own stock market predictions that they will invest in equities only if they expect a bull market in the short term. We then investigated whether our finance professors consider their past investment outcomes in deciding whether to hold equities and are thus prone to either the house-money effect or the break-even effect. Specifically, we tested whether members of this group decide whether to invest in equities on the basis of either their short-term market predictions or the outcomes of their past investments. We found no support for overconfidence (in predictions), the house-money effect, or the break-even effect. Taken together, these results suggest that our sample of finance professors is less prone to certain behavioral biases than the general public.