George M. Korniotis

Estimating Panel Models with Internal and External Habit Formation

A new bias-corrected estimator is developed for dynamic panel model with both fixed and spatial effects. The estimator is asymptotically unbiased, normally distributed, and it has good finite sample properties (low finite sample bias and root mean squared error). Applying the estimator to annual consumption data for the continental U.S. states shows that state consumption growth is not significantly affected by its own (lagged) consumption growth. However, it is affected by lagged consumption growth of nearby states. These results support external habit formation model, which have been used to explain the behavior of U.S. stock returns.

Do Portfolio Distortions Reflect Superior Information or Psychological Biases

Using a demographics-based proxy for smartness, we show that the portfolio distortions of “smart” investors reflect an informational advantage, while the distortions of “dumb” investors reflect psychological biases. Specifically, smart investors outperform dumb investors by about 3% annually on a risk-adjusted basis. Furthermore, among investors with high portfolio distortions, smart investors outperform passive benchmarks by 2%, and the smart-dumb performance differential is 5%. At the stock level, a portfolio of stocks with smart investor clientele outperforms the dumb clientele portfolio by 3.50% annually. These findings suggest that behavioral and information-based explanations for portfolio distortions apply to distinct subsets of investors.

Local Business Cycles and Local Liquidity

This study examines whether state-level economic conditions affect the liquidity of local firms. We find that liquidity levels of local stocks are higher (lower) when the local economy has performed well (poorly). This relation is stronger when local financing constraints are more binding, the local information environment is more opaque, and local institutional ownership levels and trading intensity are higher. Overall the evidence supports the notion that the geographical segmentation of U.S. capital markets generates predictable patterns in local liquidity.

Long Georgia, Short Colorado? The Geography of Return Predictability

This study investigates whether local stock returns vary with local business cycles in a predictable manner. We conjecture that, in the presence of local bias and incomplete risk sharing, local macroeconomic variables that characterize local business cycles would predict the returns of local stocks. In particular, during local economic recessions, the average returns of local stocks would increase as local risk aversion increases and the ability of local investors to smooth consumption declines. Consistent with this conjecture, we find that U.S. state portfolios earn higher (lower) returns when state-level unemployment rates are higher (lower) and state investors face stronger (weaker) borrowing constraints. During the 1980-2004 period, trading strategies that exploit this state-level predictability earn annualized risk-adjusted return of over 7 percent. The evidence of predictability is stronger among less visible firms and in regions in which investors exhibit stronger local bias and hold more concentrated portfolios. Overall, our results indicate that the stock return generating process contains a predictable local component.

Geography of Firms and Propagation of Local Economic Shocks

We use information from 10-K filings to identify economic connections among U.S. states. These connections provide a measure of economic distance that does not merely reflect physical proximity or industry connections. At the firm level, there is excess comovement in the returns and liquidity of firms headquartered in economically connected states. At the aggregate level, the economic connections create spillover effects whereby economic shocks in a state affect its connected states and the U.S. economy. For example, a one percent production shock in California (Texas) is related to a 6.71 (5.62) percent change in annual U.S. GDP growth, relative to the average GDP growth. Collectively, the network of publicly-traded firms generates a channel that facilitates the propagation of local shocks across the U.S. economy.

Stature, Obesity, and Portfolio Choice

Using multiple U.S. and European data sources, we show that observed physical attributes are related to participation in financial markets. Specifically, we find that individuals who are relatively tall and of normal weight are more likely to hold stocks in their financial portfolios. We consider several potential mechanisms that could drive the relation between physical attributes and portfolio decisions. We find that teenage social experiences as well as genetic and prenatal endowments that are fixed at birth are the two channels through which height affects financial decisions. Further, we find that the relation between body mass index and portfolio decisions is largely driven by education and race.

Prozac for Depressed States? Effect of Mood on Local Economic Recessions

This paper examines whether peoples mood and optimism affects economic activity. We consider two sets of exogenous proxies for optimism that are unrelated to the economic environment: (i) weather (average temperature and cloud cover) and (ii) sports and political optimism. We show that economic recessions are weaker, expansions are stronger, and the economic recovery is faster in U.S. states where local individuals are more optimistic. Further, local optimism has a stronger impact on state-level business cycles of smaller states and regions with low levels of risk sharing. In contrast, the incremental effects of local optimism are weaker in states where people are younger, more educated and sophisticated, and socially more connected. States with larger concentration of minority and urban population also exhibit lower sensitivity to variations in mood and optimism. Alternative explanations based on states industrial composition, tax environment, migration, seasonal affective disorder (SAD), oil shocks, and direct economic impact of weather cannot explain these findings.

Income Hedging, Dynamic Style Preferences, and Return Predictability

We propose a theoretical measure of income hedging demand and show that it affects asset prices. We focus on the value factor and first demonstrate that our demand estimates are correlated with the actual demands of retail and mutual fund investors. Then, we show that the aggregate HML demand predicts HML returns. Exploiting the state-level variation in income risk, we demonstrate that state-level hedging demands predict state-level HML returns. A long-short portfolio that exploits this hedging-induced predictability earns an annualized risk-adjusted return of 6%.

Consumption-Income Sensitivity and Portfolio Choice

Contrary to the predictions of traditional life-cycle models, households do not engage in perfect consumption smoothing. Similarly, weak evidence of income hedging runs against standard portfolio theory. We link these two puzzles by proposing a model in which investors derive utility from consumption and income status. In contrast to the traditional life-cycle model, status conscious investors use financial assets to either over- or under-hedge income fluctuations, depending on whether they treat consumption and status as complements or substitutes. We confirm the predictions of the status preference model using data from the PSID, and find that status preferences empirically affect the income hedging motive in household portfolio decisions.

Why Memory Hinders Investor Learning

We examine the dynamics of financial knowledge and investment experience on the equity portfolio decisions of U.S. investors. We find that prior portfolio choices influence investors’ future decisions. The most influential prior choices are those made near the time when the investor starts trading and in the most recent period. However, experience matters. Specifically, investors hold more stocks, reduce purchase turnover, earn higher returns, and increase the Sharpe Ratios of their portfolios as they accrue investment experience. In contrast, general financial knowledge by itself does not influence investor behavior. Rather, knowledge affects equity portfolio decisions in combination with experience. That is, as knowledgeable investors gain experience, they improve both portfolio construction and account performance.