Kent D. Daniel

Investor Psychology and Security Market Under- and Overreactions

We propose a theory of securities market under- and overreactions based on two well-known psychological biases: investor overconfidence about the precision of private information; and biased self-attribution, which causes asymmetric shifts in investors’ confidence as a function of their investment outcomes. We show that overconfidence implies negative long-lag autocorrelations, excess volatility, and, when managerial actions are correlated with stock mispricing, public-event-based return predictability. Biased self-attribution adds positive short-lag autocorrelations ~“momentum”!, short-run earnings “drift,” but negative correlation between future returns and long-term past stock market and accounting performance. The theory also offers several untested implications and implications for corporate financial policy. IN RECENT YEARS A BODY OF evidence on security returns has presented a sharp challenge to the traditional view that securities are rationally priced to ref lect all publicly available information. Some of the more pervasive anomalies can be classified as follows ~Appendix A cites the relevant literature!: 1. Event-based return predictability ~public-event-date average stock returns of the same sign as average subsequent long-run abnormal performance! 2. Short-term momentum ~positive short-term autocorrelation of stock returns, for individual stocks and the market as a whole!

Market Reactions to Tangible and Intangible Information

We decompose stock returns into components attributable to tangible and intangible information. A firms tangible return is the component of its return attributable to fundamental accounting-performance information, and its intangible return is the component which is orthogonal to this information. Our evidence indicates that intangible information reliably predicts future stock returns. However, in contrast to previous research, we find that tangible returns have no forecasting power. The premia associated with intangible information pose challenges for both traditional asset pricing models and models based on psychological factors.

Investor Psychology in Capital Markets: Evidence and Policy Implications

We review extensive evidence about how psychological biases affect investor behavior and prices. Systematic mispricing probably causes substantial resource misallocation. We argue that limited attention and overconfidence cause investor credulity about the strategic incentives of informed market participants. However, individuals as political participants remain subject to the biases and self-interest they exhibit in private settings. Indeed, correcting contemporaneous market pricing errors is probably not governments relative advantage. Government and private planners should establish rules ex ante to improve choices and efficiency, including disclosure, reporting, advertising, and default-option- setting policies. Especially, government should avoid actions that exacerbate investor biases.

Explaining the Cross‐Section of Stock Returns in Japan: Factors or Characteristics?

Japanese stock returns are even more closely related to their book-to-market ratios than are their U.S. counterparts, and thus provide a good setting for testing whether the return premia associated with these characteristics arise because the characteristics are proxies for covariance with priced factors. Our tests, which replicate the Daniel and Titman (1997) tests on a Japanese sample, reject the Fama and French (1993) three-factor model but fails to reject the characteristic model.

Testing Factor-Model Explanations of Market Anomalies

A set of recent papers attempts to explain the size and book-to-market anomalies with conditional CAPM or CCAPM models with economically motivated conditioning variables, or with factor models with economically motivated factors. The tests of these models, as presented, fail to reject the proposed model. We argue that these tests fail to reject the null hypothesis because they have very low statistical power against what we call the characteristics alternative. Specifically, the low power of these tests arises because they use as test portfolios, characteristic-sorted portfolios that do not have sufficient independent variation in the factor loadings and the characteristics. We propose several methods for constructing more appropriate test portfolios and for designing more powerful tests. We show that with these more powerful tests the models we examine are rejected at high levels of statistical significance.

EQUITY-PREMIUM AND RISK-FREE-RATE PUZZLES AT LONG HORIZONS

The failure of consumption-based asset pricing models to match the stochastic properties of the equity premium and the risk-free rate has been attributed by some authors to frictions, transaction costs, or durability. However, such frictions primarily would affect the higher-frequency data components: Consumption-based pricing models that concentrate on long-horizon returns should be more successful. We consider two consumption-based models: time-separable utility, and the habit model of Constantinides. We estimate a vector ARCH model that includes the pricing kernel and the equity return, and use the fitted model to assess the models implications for the equity premium and for the risk-free rate. Neither model performs well at a quarterly horizon, but at longer horizons the Constantinides model can match the mean and the variance of the observed equity premium, captures time variation of the equity premium, and can better match the observed risk-free rate. We conclude that the equity-premium and risk-free-rate puzzles are primarily problems for shorter-horizon returns.

Overconfident Investors, Predictable Returns, and Excessive Trading

Individuals and asset managers trade aggressively, resulting in high volume in asset markets, even when such trading results in high risk and low net returns. Asset prices display patterns of predictability that are difficult to reconcile with rational expectations–based theories of price formation. This paper discusses how investor overconfidence can explain these and other stylized facts. We review the evidence from psychology and securities markets bearing upon overconfidence effects, and present a set of overconfidence-based models that are consistent with this evidence.

The power and size of mean reversion tests

The power of mean reversion tests has long been a tacit issue of the market efficiency literature. Early tests of market efficiency, as summarized in Fama Ž . 1970 , found no economically significant evidence of serial correlation in stock Ž . returns. However, Summers 1986 later suggested that this was because these tests lacked power: Summers suggested a model of AfadsB in which stock prices take long swings away from their fundamental values, and showed that even if a fads component such as this accounted for a large fraction of the variance of returns, the fads behavior might be difficult to detect by looking at short horizon autocorrelations of returns as these early tests had done. The intuition behind Summers’ reasoning was that if stock prices took large jumps away from their AfundamentalB or full-information values, and then only reverted back towards the fundamental price over a period of years, the autocorrelations of monthly or daily returns would capture only a small fraction of this mean reversion. Several attempts were made to develop tests that would have greater power Ž . against AfadsB hypotheses such as Summers’. Fama and French 1988a used a long horizon regression of multi-year returns on past multi-year returns, and Ž . Poterba and Summers 1988 used a variance ratio test to look for fads-type behavior in stock-index returns. In addition, variance ratio test are used by Ž . Ž . Cochrane 1988 and Lo and MacKinlay 1988 to investigate the time series properties of production and short horizon returns.

The Carry Trade: Risks and Drawdowns

We find important differences in dollar-based and dollar-neutral G10 carry trades. Dollar-neutral trades have positive average returns, are highly negatively skewed, are correlated with risk factors, and exhibit considerable downside risk. In contrast, a diversified dollar-carry portfolio has a higher average excess return, a higher Sharpe ratio, minimal skewness, is unconditionally uncorrelated with standard risk-factors, and exhibits no downside risk. Distributions of drawdowns and maximum losses from daily data indicate a role for timevarying autocorrelation in determining negative skewness at longer horizons.

Another Look at Market Responses to Tangible and Intangible Information

As Gerakos and Linnainmaa (2016) point out, the Daniel and Titman (2006) decomposition of returns into tangible and intangible components can potentially be ambiguous. In particular DT’s book-return, the adjusted growth rate in book value per-share which DT use as a tangible measure of long-term performance, can be affected by a firm’s issuance and repurchase choices as well as by its profitability. This paper clarifies the relation between total book equity growth, our book-return measure, and our composite share issuance variable, and shows that our earlier conclusions are robust. We also provide out-ofsample tests.