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Behavioral finance
In this section, the reports deal with articles on behavioral finance: the assumptions, the models, the empirical studies etc..It is one of the most actively researched field in finance.

The Small World of Investing

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The Small World of Investing: Board Connections and Mutual Fund Returns

The paper, by Lauren Cohen, Andrea Frazzini, and Christopher Malloy, studies the private information flowing from top senior officers of publicly traded companies to mutual fund managers connected through a network. The authors deem that mutual fund managers are likely to place larger bets in firms run by people in their education network and earn higher returns on these investments. In addition, the authors examine the returns of connected and non-connected stocks around news events. 

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Aspects of Investor Psychology

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Aspects of Investor Psychology

Introduction
The authors, Daniel Kahneman and Mark W. Riepe, discuss three methods for the analysis of decisions. Normative analysis is related to the ideal decisions that people should make. Descriptive analysis involves the approach through which real people actually make decisions. Finally, prescriptive analysis is connected with practical advice and help that people could utilize to make rational decisions. Accordingly, financial advising is a perspective action whose target must be to direct investors to make decisions befitting their interests.

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All that Glitters (...)

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All that Glitters: The Effect Of Attention and News on the Buying Behavior of Individual and Institutional Investors

The authors, Brad M. Barber and Terrance Odean, corroborate the hypothesis that individual investors usually buy attention-grabbing stocks while institutional investors like hedge funds are least influenced by attention. 
I. Related Research
The authors highlight the behavior of investors during large price moves and how the attention of first-time buyers’ investors is grabbed by the event of hitting a price limit. Besides, firms that spend more on advertising have a large number of individual and institutional investors. Additionally, stocks experiencing unusually high trading volume over a day or week are expected to witness price increase subsequently, thereby attracting new investors.
II. Data
The authors evaluate trading data drawn from four sources - a large discount brokerage, a small discount brokerage, a large full-service brokerage and the Plexus Group, a consulting firm active in tracking the trading of professional money managers for institutional clients.
III. Sort Methodology
A. Volume Sorts: The increase in the tendency of investors to buy stocks on days of unusually high trading volume for the above four investor groups is studied. 
B. Return Sorts: Positive or negative returns generate price changes accordingly. The authors examine how big price changes, where positive or negative, attract the attention of the four investor groups.
C. News Sorts: Firms that are in the news are liable to attract investors’ attention.
IV. Results
A. Volume Sorts: Results of buy-sell imbalances in the four investors groups are shown.
B. Return Sorts: Here too, results of buy-sell imbalances in the four-investor groups are presented. 
C. News Sorts: Results of buy-sell imbalances for stocks of firms in and not in news are given.
D. Volume, Return, and News Sorts: Buy-sell imbalance for stocks segregated on abnormal trading volume, previous day’s return and news coverage of a stock are analyzed. In addition, it is found that abnormal trading volume is the best indicator of attention. 
E. Size Partitions: By calculating buy-sell imbalances separately for small, medium, and large capitalization stocks, the authors find that investors buy attention-grabbing stocks without considering their size.
F. Earnings and Dividend Announcements: Finally, buy-sell imbalances for abnormal partitions, return partitions, news and no-news for earnings announcement days, dividend announcement days and other days are computed.            
V. Short-sale Constraints: Individual investors, who become bullish, are able to buy stock, but those who become bearish can sell it only if they are willing to sell short or already own it. Investors are not likely to sell attention-grabbing stocks.
VI. Conclusion
Individuals tend to buy attention-driven stocks. However, when it comes to selling, investors have a tendency to sell stocks that they already own i.e. they don’t sell short. Usually, investors pick stocks from the thousands of stocks by buying the one that attracts their attention. Majority of investors hold small number of common stocks in their portfolio. But, institutional investors, not driven to buy attention-grabbing stocks, have more stocks to sell than an individual. In addition, institutional investors can narrow their search for buying stocks in a particular sector or matching specific criteria. Three measures related with attention-grabbing events include news, unusual trading volume and extreme returns (positive or negative). Moreover, individual investors actively buy stocks on high attention days. Evidently, for every buyer there is a seller. Consequently, professional investors tend to buy, rather than sell, on high attention days and vice versa during low attention days. Furthermore, attention-driven buying is similar for small stocks and large capitalization stocks.  

http://faculty.haas.berkeley.edu/odean/papers/Attention/All%20that%20Glitters.pdf

 

Down or Out: Assessing the Welfare Costs (...)

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Down or Out: Assessing the Welfare Costs of Household Investment Mistakes


This paper, by Laurent E. Calvet, John Y. Campbell and Paolo Sodini, studies the effectiveness of the Swedish household population’s investment strategies and analyses the main causes of inefficiency – underdiversification (down) and nonparticipation in risky asset markets (out). The Swedish data records are, thus, utilized to determine the individual financial assets of all households, accounted by financial institutions and verified by taxpayers.

Following the assessment of the means of Swedish household portfolio returns, four results were obtained. First, in many household portfolios, direct stockholdings are dominated by mutual funds and cash, thereby restricting the loss returns from concentrated stock portfolios. Second, a minor part of Swedish households seem to be exceedingly underdiversified. Third, sophisticated Swedish households are likely to invest efficiently and aggressively, in so doing, increasing the return loss from the portfolio inefficiency of these households. Fourth, nonparticipating households are predisposed to invest poorly in risky asset markets.


Household Asset Allocation
1. Data Summary: The authors have provided a concise interpretation of the Swedish economy and tax system
2. Aggregate Asset Allocation: The aggregate gross wealth of households is estimated by calculating the value of financial and real estate assets held by the household 
3. Asset Allocation in Cross-Section: Following the investment patterns of households, it has been observed that mutual funds play a vital role in household diversification. In addition, average financial wealth is significantly higher for participating households than nonparticipating households

Diversification of Household Portfolios
1. Idiosyncratic and Systematic Risk: The authors analyze the asset returns and characteristics of household portfolios  
2. Contributors to Idiosyncratic Risk: The assessment of idiosyncratic volatility of household risky portfolios is done  
3. Estimating the Mean Returns of Household Portfolios: The global Capital Asset Pricing Model (CAPM) is used for the analysis of international diversification
4. Mean-Variance Measure of Diversification:
o Relative Sharpe Ratio Loss: The authors calculate diversification losses by comparing the Sharpe ratio of a household portfolio with the benchmark index
o Return Loss: The inefficiency of household portfolio is discussed by computing the return losses for households’ risky and complete portfolios 
o Connecting the Dots: Summary of the previous results

Who is Underdiversified?
It has been discerned that characteristics of households determine the characteristics of the portfolios they hold. Households with financial sophistication invest in risky assets and prefer diversified portfolios, thus bearing higher return losses. Conversely, less sophisticated households such as entrepreneurs, retirees and unemployed dummies, owing to their restricted investment skills, invest in lower risky shares and endure fairly lower return losses.
1. Robustness Checks: Tax optimization strategies lead to inefficiency in some household portfolios 
Down or Out?
1. Who Participates in Risky Asset Markets?: The analysis of active participants in risky asset markets is carried out 
2. The Welfare Cost of Nonparticipation: The authors estimate the return lost by a nonparticipating household
Conclusion
Many Swedish households are efficiently diversified. These households achieve international diversification through the equity and balanced mutual funds sold by the domestic markets.      

Reference

Calvet, Laurent E., Campbell, John Y. and Sodini, Paolo, "Down or Out: Assessing the Welfare Costs of Household Investment Mistakes" (February 2006). Harvard Institute of Economic Research Discussion Paper No. 2107 Available at SSRN: http://ssrn.com/abstract=881768

 

 

Systematic Noise

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Systematic Noise

Brad M. Baber, Terrance Odean, Ning Zhu


This paper investigates the essential conditions for the prejudices and sentiments of individual investors to influence asset prices (the systematic noise). Firstly, the limitations of well-informed traders must counterbalance the pricing effects of sentiment driven trading. Secondly, the trading by individual investors is systemic and guided by their own decisions.
Hypothesis Development
Factors that affect the trades of individual investors are:
· Changing Risk Preferences: Investors’ risk preferences vary over time
· Rebalancing: Rebalancing coordinates sales
· The Disposition Effect: The affinity of investors to sell wining stocks and retain losing stocks (strictly applicable to selling decisions)
· Tax-Loss Selling: Investors prefer selling losing stocks to balance capital gains
· Information: Individual investors having superior knowledge tend to buy undervalued stocks and sell overvalued stocks
· Representativeness: Representativeness heuristic forecasts that investors overweigh past returns when valuing stocks  
· Attention: Investors are inclined to buy stocks that attract their attention based on their personal preferences
· Summary: Synopsis of the hypotheses
Data and Methods
· Trades Data: Analysis of trading behavior of individual investors
· Distribution Analysis: Study to determine that trading decisions are independent across stocks
· Correlation Analysis
o Contemporaneous Correlation: Calculation of correlation in the trading decision of randomly assigned groups
o Time Series Correlation: Calculation of correlation of buying intensity over time
· Concentration Measures: Determination of concentration of buying and selling
· Performance: Assessment of performance and style characteristics of stocks heavily bought or sold by individual investors 
Results
· Independence Results
o Distribution Results: The trading decisions of individual investors are not independent
o Contemporaneous and Time-Series Correlations: Strong persistence present in buying intensity over time
· Concentration Results: Buying is more concentrated than selling
· Results by Firm Size: Calculation and results of persistence of buying intensity individually for small, medium, and large stocks
· Limit vs. Market Orders: Results of limit orders vs. market orders 
· Cross-Sectional Regressions: Results of the relation between trading and past returns
· Complete vs. Partial Sales: Independent analysis of complete and partial sales of a security and their relation with past returns
· Performance: Study of returns on stocks heavily bought vs. heavily sold
Institutional Herding
Herding indicates situations where correlated behavior arises from individuals scrutinizing and responding to behavior of others.     
Discussion
The facts regarding the trading of individual investors have been established. Several factors such as rebalancing, superior information, tax-loss selling, and changing risk preferences might not coordinate the trading of individual investors. Buying decisions are dominated by representativeness heuristic and attention.  
Conclusion
The buying and selling behavior of individual investors is systematic. In addition, the buying and selling decisions of individuals are highly correlated and they cumulate over time. Individual investors (noise traders) possess the ability to affect asset prices because their noise is systematic.

Barber, Brad M., Odean, Terrance and Zhu, Ning, "Systematic Noise" (May 2006). AFA 2004 San Diego Meetings Available at SSRN: http://ssrn.com/abstract=474481

 


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