Overconfidence in personal beliefs and inattention to new trends are widespread in financial markets. If specific behavioural biases become common across investors they constitute sources of mispricing and – hence – return factors. Indeed, overconfidence and inattention can be quantified as factors to an equity market pricing model and seem to capture a wide range of pricing anomalies. This suggests that detecting sources of behavioural biases, such as attachment to ideological views or laziness in the analysis of data, offers opportunities for systematic returns.
The post ties in with SRSV’s lecture on information inefficiency.
The below are excerpts from the paper. Emphasis and cursive text have been added.
“Overconfident investors overestimate the precision of signals they receive, and accordingly overreact to private information and underreact to public information about economic factors that influence profits…[This leads] to a value effect wherein firms with high stock valuations relative to fundamental measures subsequently experience low returns. Owing to overconfidence in their private signals, investors are relatively unwilling to correct their perceptions as further (public) earnings news arrives…So in contrast with a limited-attention-driven anomaly, the correction of overconfidence-driven mispricing will take place over a much longer time horizon.”
“Limited investor attention induces…market underreaction to public information…For example, a subset of investors fails to take into account the implications of the latest earnings surprise for future earnings. As a consequence, stock prices underreact to earnings surprises. This results in abnormal returns in the form of post-earnings announcement drift (PEAD) when this mispricing is corrected upon the arrival of the next few earnings announcements.”
N.B.: Inattention to high-frequency information is more plausible in respect to global economic data releases, which are far more numerous, subject to many distortions and often hard to interpret as to their impact on individual assets.
“Behavioral models motivate the use of factor exposures as proxies for security mispricing. Intuitively, when investors are imperfectly rational and make similar errors about related stocks…sentiment shocks can induce co-movement of assets that share the same style, even when news about the assets’ underlying cash flows is uncorrelated…Alternatively, return co-movement can result from commonality in investor errors in interpreting signals about fundamental economic factors.”
“In behavioral models there will be co-movement associated with common levels of mispricing, as well as with common exposure to fundamental risk factors. Since mispricing predicts future returns owing to subsequent correction of the mispricing, this implies that behavioral factors can be used to construct a factor model…We use behavioral factors based on characteristics that are expected to be associated with misvaluation.”
An application to equity markets
“We propose a factor model that augments the CAPM with two behaviorally-motivated factors. These factors…capture misvaluation resulting from psychological biases… Specifically, by combining behavioral factors with the market factor (to capture rational risk premia) we seek to describe parsimoniously anomalies at both short- and long-horizons.”
“Our long-horizon behavioral factor is based upon security issuance and repurchase… [Company] managers possess inside information about the true value of their firms and issue or repurchase equity (or debt) to exploit pre-existing mispricing. Firms undertaking share issues will generally be overpriced and repurchasing firms underpriced…Under this hypothesis, investors hold stubbornly to their mistaken beliefs upon observing the new issue or repurchase, perhaps owing to overconfidence. If investors are overconfident, a few corrective earnings announcements may not be enough to fully eliminate misperceptions, so abnormal performance can persistent for a long period of time…We create a [overconfidence] factor based on the 1-year net-share-issuance and 5-year composite-issuance measures.”
N.B.: This type of factor can be extended to fixed income and foreign exchange markets to the extent that governments and central banks issue bonds or intervene against exuberant and depressed markets.
“Our second behavioral factor is designed to capture short-term mispricing, such as underreaction to earnings information. Post-earnings announcement drift (PEAD) is the finding that firms that experience positive earnings surprises subsequently outperform those with negative earnings surprises…The premium earned by a PEAD is not a rational risk premium. .A recent empirical literature suggests that this delayed response is attributable to limited investor attention… Our PEAD [inattention] factor is constructed by going long firms with positive earnings surprises and short firms with negative surprises.”
The empirical finding
“We empirically assess the incremental ability of behavioral factors to explain expected returns relative to the factors used in other models….We first…examine how well other factors explain the performance of [the overconfidence factor] and [the inattention factor] and vice-versa. We find that a factor model that includes both [the overconfidence factor] and [the inattention factor] prices most of the traded factors proposed in the literature…In sharp contrast, reverse regressions show that these other factors do not fully explain the abnormal returns associated with [the overconfidence factor] and [the inattention factor].”
“Why do just two return predictors capture a wide set of anomalies? This result does not imply that anomalies derive from just two psychological sources. Rather, it is plausible that there are many behavioral biases, each somewhat different. However, to the extent that each firm’s manager is aware of that firm’s total mispricing, resulting from this variety of biases, and attempts to arbitrage this mispricing via issuance/repurchase activities the scale of which is proportional to the magnitude of the mispricing, we would expect our long-horizon behavioral factor to provide a good summary of the various sources of longer-term mispricing. Similarly, to the extent that short-horizon anomalies are related to psychological biases that induce underreaction to fundamentals, a firm’s earnings information may be a good summary of higher-frequency information about firm value that investors misvalue.”
“We confirm that estimated [overconfidence factor] loadings strongly forecast future returns, even after controlling for the firm characteristics that underlie 34 anomalies that we examine. In contrast, estimated [inattention factor] loadings have no return predictive ability. It is not clear how to interpret the [inattention factor] finding, since there are econometric issues related to instability of the firm loadings.”
N.B.: Inattention to earnings surprises is far less plausible than inattention to attendant factors, such as relevant economic trends, financial conditions changes and regulatory policies, all of which are much harder to track and interpret.