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Behavioural finance

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Behavioural Finance Research.

Behavioural finance is a growing field of study in both corporate finance and asset pricing. It seeks for answers to questions that are hard to be explained by traditional finance theories. Researchers investigate seemingly irrational decisions made by corporate managers and investors, applying findings from the psychology literature on human beings’ cognitive bias in decision making. 

One interesting feature observed in financial markets is anchoring. Anchoring is a cognitive bias that describes the common human tendency to rely excessively on the information offered in the past (the ‘anchor’) when making decisions. CCFin researchers have shown that corporate managers rely on initial public offer (IPO) price when they are setting firms’ nominal stock price level. IPO prices are natural anchors because they are the first public prices observed by investors. We show that nominal prices of most stocks around the world tend to revert to their initial public offer (IPO) prices and corporate actions, such as (reverse) stock-split and large dividend payout, maintain these nominal stock price anchors. 

Research at CCFin also finds that the anchoring bias affects investors’ trading behaviours as well. In particular, we show that investors use the 52-week high (i.e., the highest stock price during the past one year) as an anchor when reacting to earnings news. When firms make positive earnings announcements and if the stocks prices of such firms are near to their 52-week highs, investors tend to underreact to the positive information contained in the earnings announcements because they are reluctant to believe that the prices would rise up any further. On the other hand, when firms make negative earnings announcements and the stock prices of such firms are far from their 52-week highs, investors tend to underreact to the negative earnings news because they are unwilling to believe the stock prices would go down any future.

Another important component of behavioural finance is probability weighting which captures the psychological bias that individuals overestimate probabilities of extreme events. One research area of focus at CCFin is to understand the impact of probability weighting on the trading behaviours of retail investors. We study theoretical models of asset liquidation where the inclusion of probability weighting can produce a number of features consistent with the empirical patterns of stock trading. These include, for example, the well-observed anomaly that investors tend to sell winning stocks too early but hold losing stocks too long, the usage of stop-loss orders and investors’ desire for trading profit with a right-skewed distribution.

George, T.J., Hwang, C.-Y. and Li, Y. (2015) “Anchoring, the 52-week high and post earnings announcement drift.” (DOI: 10.2139/ssrn.2391455) (available online via the SSRN)

Bae, K.-H., Kang, J. and Rhee, S.G. (2016) “Nominal stock price anchors: a global phenomenon?” (DOI: 10.2139/ssrn.2583954)

Henderson, V., Hobson, D. and Tse, A.S.L. (2017) “Probability weighting, stop-loss and the disposition effect.” (DOI: 10.2139/ssrn.2823449) (available online via the SSRN)

Henderson, V., Hobson, D. and Tse, A.S.L. (2017) “Randomized strategies and prospect theory in a dynamic context.” Journal of Economic Theory, 168: 287-300 (DOI: 10.1016/j.jet.2017.01.003)

George, T., Hwang C.-Y. and Li, Y. (2018) “The 52-week high, q theory and the cross-section of stock returns.” Journal of Financial Economics (forthcoming)