Finance

How Investor Psyche Affects Stock Pricing

AT THE ZENITH of the dot-com craze when Palm Inc. spun off from parent 3COM, its March 2, 2000, IPO touched off a stampede of over-eager investors elbowing their way into the action. When the dust settled at the end of the day, Palm’s worth surpassed its parent, even overtaking such titans as Ford and gm.

“3COM owned 94 percent of Palm,” points out Ming Huang, an assistant professor of finance who has conducted research in the burgeoning field of behavioral finance. “Yet Palm was trading so high that 3COM’s value was much lower than Palm’s. It didn’t make any sense.”

In academia, financial economists were hard put to explain this and other stock behavior in the frenzied months leading up to the bursting of the dot-com bubble. The highly irrational pricing of Internet stock—especially at IPO—did not square with the traditional approach to the study of financial markets, which assumes that markets are always efficient and participants always rational. The traditional view that “smart money” in the market will take advantage of human mistakes and thereby drive prices back to equilibrium could not explain the collective faulty judgment of a broad base of investors and their impact on stock prices.

“Financial economists have long been aware that in laboratory settings, humans often make systematic mistakes and choices that cannot be explained by traditional models of choice under uncertainty,” says Paul Pfleiderer, the William F. Sharpe Professor of Financial Economics. “We are now willing to consider that some of those lab-observed behaviors may affect pricing in financial markets after all.”

In light of the dot-com bomb, the questions are: Which behaviors? And how do they affect pricing?

“The good news is that behavioral finance is at the heart of what finance is all about, and that is: What drives stock prices? What drives investors’ decision making? The price part is the key,” says Harrison Hong, an associate professor of finance and a leading voice in the resurgence of the field’s popularity.

He and fellow faculty member Huang have been perhaps the most visible agents provocateurs of the finance status quo. “They are at the forefront in developing rigorous models that will give us insight into how deviations from our standard assumptions might have important effects on pricing,” says Pfleiderer.

While Hong has studied asset pricing from the angle of collective investor beliefs, Huang has examined the impact on pricing of investors’ preferences toward risk.

“The research my coauthors and I worked on proposed to explain an array of pricing phenomena, or anomalies, by merging the traditional asset pricing approach with some evidence from psychology literature of human beings’ preferences when faced with uncertainty—what’s called the prospect theory,” says Huang. The theory demonstrates, among other findings, that people care about changes in financial wealth rather than absolute value, and that they are more sensitive to losses than to gains relative to certain reference points, like the price paid for a stock.

Huang and his collaborators specifically showed that their framework can help explain why stock investment returns historically exceed interest rates by 6 percent, and why price-earnings ratios tend to fluctuate more widely than can be justified by cash flow news. They also have applied this framework to study the predictability of individual stock returns.

Hong and his coauthors have modeled and measured the impact of investors’ collective beliefs on asset prices. “Rather than saying, ‘investors make errors,’ we know it’s more accurate to say there are different degrees of rationality,” says Hong. “Some people are very rational—the professional money or hedge fund types—while others have limitations in their formation of accurate expectations. What happens when you put these people together and you look at the equilibrium prices that result? My research explores that interaction.” Specifically, his research shows that simple models of asset pricing featuring these interactions can efficiently reconcile a number of stock price phenomena such as momentum in stock prices, the overvaluation of IPOs such as that of Palm Inc., and market crashes.

In his most recent research, Hong looks at what determines investors’ beliefs and tests the idea that stock market participation is influenced by social interaction.

“There is a lot of evidence on prices that indicates markets are predictable,” says Hong. “Now we’re taking steps toward bridging the gap between hypothesis and rigorous, empirical testing. I think that’s what behavioral finance is about.”

— HELEN K. CHANG

Related Research:
Social Interaction and Stock Market Participation
Breadth of Ownership and Stock Returns
Forecasting Crashes: Trading Volume, Past Returns, and Conditional Skewness in Stock Prices
Bad News Travels Slowly: Size, Analyst Coverage, and the Profitability of Momentum Strategies

Text of research by Ming Huang: 
Mental Accounting, Loss Aversion, and Individual Stock Returns
Prospect Theory and Asset Prices