Naive Investors Research Articles

Does Investors' Sophistication Affect Persistence and Pricing of Discretionary Accruals?

This paper examines whether the sophistication of market investors influences management's strategy on discretionary accounting choice, and thus changes the persistence of discretionary accruals. The results show that the persistence of discretionary accruals for firms face with naive investors is lower than that for firms face with sophisticated investors. The results also demonstrate that sophisticated investors indeed incorporate the implications of current earnings components into future earnings in a more sufficient manner than naïve investors do.

Are stock prices too volatile to be justified by the dividend discount model?

This study investigates excess stock price volatility using the variance bound framework of LeRoy and Porter [The present-value relation: tests based on implied variance bounds, Econometrica 49 (1981) 555–574] and of Shiller [Do stock prices move too much to be justified by subsequent changes in dividends? Am. Econ. Rev. 71 (1981) 421–436.]. The conditional variance bound relationship is examined using cross-sectional data simulated from the general equilibrium asset pricing model of Brock [Asset prices in a production economy, in: J.J. McCall (Ed.), The Economics of Information and Uncertainty, University of Chicago Press, Chicago (for N.B.E.R.), 1982]. Results show that the conditional variance bounds hold, hence, our hypothesis of the validity of the dividend discount model cannot be rejected. Moreover, in our setting, markets are efficient and stock prices are neither affected by herd psychology nor by the outcome of noise trading by naive investors; thus, we are able to control for market efficiency. Consequently, we show that one cannot infer any conclusions about market efficiency from the unconditional variance bounds tests.

Are Stock Prices Too Volatile to be Justified by the Dividend Discount Model?

This study investigates excess stock price volatility using the variance bound framework of LeRoy and Porter (1981) and of Schiller (1981). The conditional variance bound relationship is examined using cross-sectional data simulated from the general equilibrium asset pricing model of Brock (1982). Results show that the conditional variance bounds hold, hence, our hypothesis of the validity of the dividend discount model cannot be rejected. Moreover, in our setting, markets are efficient and stock prices are neither affected by herd psychology nor by the outcome of noise trading by naive investors; thus, we are able to control for market efficiency. Consequently, we show that one cannot infer any conclusions about market efficiency from the unconditional variance bounds tests.

Advisors and Asset Prices: A Model of the Origins of Bubbles

We develop a model of asset price bubbles based on the communication process between advisors and investors. Advisors are well-intentioned and want to maximize the welfare of their advisees (like a parent treats a child). But only some advisors understand the new technology (the tech-savvies); others do not and can only make a downward-biased recommendation (the old-fogies). While smart investors recognize the heterogeneity in advisors, naive ones mistakenly take whatever is said at face value. Tech-savvies inflate their forecasts to signal that they are not old-fogies, since more accurate information about their type improves the welfare of investors in the future. A bubble arises for a wide range of parameters, and its size is maximized when there is a mix of smart and naive investors in the economy. Our model suggests an alternative source for stock over-valuation in addition to investor overreaction to news and sell-side bias.

Adaptive Expectations and Stock Market Crashes

A theory is developed that explains how the stock market can crash in the absence of news about fundamentals, and why crashes are more common than frenzies. A crash occurs via the interaction of rational and naive investors. Naive traders believe in a simple (but reasonable) statistical model of stock prices: that prices follow a random walk with serially correlated volatility. They predict future volatility adaptively, as a weighted average of past squared price changes. In a crash, the naive traders lower their demand in response to the apparent increase in volatility. This lowers the risk bearing capacity of the market, so that the lower crash price clears the market. Unlike other explanations of market crashes, this mechanism is fundamentally asymmetric: the stock price cannot rise sharply, so frenzies or bubbles cannot occur.

An Empirical Analysis of the Effects of Online Trading on Stock Price and Trading Volume Reactions to Earnings Announcements*

AbstractThis study provides evidence regarding the effects of online trading on stock price and trading volume reactions to quarterly earnings announcements. We test for differences in stock price and volume reactions to quarterly earnings announcements between a period with a significant amount of online trading (1996‐99) and a period without online trading (1992‐95). We conjecture that online trading has increased the proportion of naive investors in the market. We predict that this will result in (1) a decrease in the average precision of investor information prior to earnings announcements leading to higher earnings response coefficients (ERCs), (2) an increase in differential interpretation of earnings leading to higher trading volume reactions that are unrelated to price change, and (3) a decrease in differential prior precision leading to a decrease in the association between trading volume and absolute price change. We find evidence consistent with all three predictions. Our findings are relevant for assessing the validity of concerns about online trading expressed by regulators and the validity of theoretical models of trade with asymmetrically informed investors.

Fifty-Fifty. Stock Recommendations and Stock Prices. Effects and Benefits of Investment Advice in the Business Media

The business media play an active role in influencing stock prices. Statistically significant excess returns at the time of the publication of stock recommendations have been documented many times. Frequently these abnormal gains begin to accumulate long before the publication date. In most cases they reach their highs on the day the recommendations are disseminated to the public. With few exceptions a price reversal sets in shortly thereafter: Excess returns in recommended stocks are at least partially given up. Many stocks now enter a period of underperformance, earning significant negative returns. The return reversions indicate that such stock price reactions are due to price pressure from naive investors hoping to profit from the experts. However, most media lack any real information that is not yet reflected in stock prices. In short: There is no evidence that stock recommendations published in the media offer any systematic opportunity to outperform the market. The evidence leads to the opposite conclusion: That investors who follow such advice will lose in the long run.

Portfolio managers' and novices' forecasts of risk and return: are there predictable forecast errors?

AbstractThis study aims to investigate the individual behaviour that underlies the overreaction hypothesis by conducting a controlled experiment. Two areas that were not captured by previous research on the validity of the overreaction hypothesis are investigated. First, actual portfolio managers are employed as forecasters. Second a real‐world assessment task is given in the form of predicting the prices of stocks traded on the exchange on a real time basis. The purpose is to explore return expectations and risk perceptions of portfolio managers as well as financially unsophisticated investors by using point and interval forecasts provided for different forecast horizons in bull and bear markets. Contributions stem from three sources. (1) The use of financially sophisticated subjects for the first time in an experimental framework testing the overreaction hypothesis makes possible to control for the effect of expertise. (2) The use of different forecast horizons controls for the effect of forecast period. (3) The use of real‐time forecasts of specific stocks traded at the stock exchange, for the first time in an experimental framework testing the overreaction hypothesis enables to control for ecological validity. Discussions will be given as to the portfolio managers' versus naive investors' interpolating asset prices from past trends and hedging behaviour, due to their caution in projections of ranges for future prices. Copyright © 2002 John Wiley & Sons, Ltd.

Discussion of The Value Relevance of Revenue for Internet Firms: Does Reporting Grossed‐up or Barter Revenue Make a Difference?

The extent to which firms manipulate reported accounting numbers and the valuation implications of such manipulation are relevant to the deliberations of accounting policy makers as well as the present academic discourse on market efficiency and the consequences of firms' disclosure choices. Davis contributes to our understanding of these phenomena by evaluating the revenue disclosure policies of 272 Internet firms during the time period spanning the first quarter of 1998 and the last quarter of 2000 (846 firm-quarters). The primary results are: (1) revenues are incrementally value relevant vis-a-vis other accounting constructs (e.g., earnings and equity book value); (2) approximately 14% (18%) of sample firms include grossed-up (barter) revenue in their reported revenue; and, (3) the valuation multiples on revenues of firms that report grossed-up or barter revenue decline after the devaluation of Internet equities in April 2000 and the rate of decline is increasing in the level of individual investor following. Taken together these results lead Davis to conclude that managers of Internet firms have an incentive to overstate revenues, some managers respond to this incentive by reporting grossed-up or barter revenue and that potentially naive individual investors influence the pricing of these discretionary accounting choices.

Portfolio Managers and Novices' Forecasts of Risk and Return: Are There Predictable Forecast Errors?

This study aims to investigate the individual behavior that underlies the overreaction hypothesis by conducting a controlled experiment. Two areas that were not captured by previous research on the validity of the overreaction hypothesis are investigated. First, actual portfolio managers are employed as forecasters. Second a real world assessment task is given in the form of predicting the prices of stocks traded on the exchange on a real time basis. The purpose is to explore return expectations and risk perceptions of portfolio managers as well as financially unsophisticated investors by using point and interval forecasts provided for different forecast horizons in bull and bear markets. Contributions stem from three sources. (1) The use of financially sophisticated subjects for the first time in an experimental framework testing the overreaction hypothesis makes possible to control for the effect of expertise. (2) The use of different forecast horizons controls for the effect of forecast period. (3) The use of real time forecasts of specific stocks traded at the stock exchange, for the first time in an experimental framework testing the overreaction hypothesis enables to control for ecological validity. Discussions will be given as to the portfolio managers' versus naive investors' interpolating asset prices from past trends and hedging behavior, due to their caution in projections of ranges for future prices.

An Empirical Analysis of the Effects of Online Trading on Investor Reactions to Earnings Announcements

This study provides evidence regarding the effects of online trading on stock market reactions to quarterly earnings announcements. We test for differences in stock price and volume reactions to quarterly earnings announcements between a period with a significant amount of online trading (1996-1999) and a period without online trading (1992-1995). We conjecture that online trading has increased the proportion of naive investors in the market. Based on noisy rational expectations models of trade, we predict that this will result in larger stock price and trading volume reactions to earnings announcements. We find strong evidence in support of these predictions. The stock price results suggest that the advent of online trading has decreased average prior precision and the trading volume results suggest that online trading has increased differential belief revisions around earnings announcements. An analysis of the relation between volume reactions and price reactions in both periods suggests that the increase in differential belief revisions is primarily due to an increase in the differential interpretation of earnings announcements in the online trading period. Our findings are relevant for assessing the validity of concerns about online trading expressed by regulators and the validity of theoretical models of trade with asymmetrically informed investors.

Accruals and Future Stock Returns: Tests of the Naive Investor Hypothesis

We explore whether the association between accruals and future returns documented by Sloan (1996) is due to fixation by naive investors on the total amount of reported earnings without regard for the relative magnitude of the accrual and cash flow components. Contrary to the predictions of the naive investor hypothesis, we find that the predictive ability of accruals for subsequent annual returns and for quarterly earnings-announcement stock returns is not lower for large firms or for firms followed more by analysts or held more by institutions. Further, we find that the ability of accruals to predict future returns does not seem to depend on stock price or transaction volume, measures of transaction costs, also contrary to predictions of the naive investor hypothesis. These results are robust to regression and hedge portfolio tests. We conclude that the predictive ability of accruals for subsequent returns does not seem to be due to the inability of market participants to understand value-relevant information.

Price Pressure: Evidence from the “Dartboard” Column

The author investigates whether analysts' recommendations in the 'Dartboard' column of the Wall Street Journal have an impact on stock prices and whether this impact is temporary or long-lived. He documents a significant two-day announcement effect that is reversed within fifteen days. This announcement effect is intertwined with the pros' track record. The author's study supports the price pressure hypothesis: abnormal returns and trading volumes around the announcement day are mainly driven by noise trading from naive investors. On average, investors following the experts' recommendations lose 3.8 percent on a risk-adjusted basis over a six-month holding period. Copyright 1999 by University of Chicago Press.

Contrarian Investment in the Dutch Stock Market

The efficient markets hypothesis states that at any time security prices fully reflect all available information. Contrarian investment strategies do not recognize the efficiency of capital markets. They call for buying undervalued stocks, i.e., stocks with a low price relative to their fundamentals. The idea behind such a strategy is to take advantage of the extrapolation behavior of naive investors. Using a fresh and extensive data set from the Dutch stock market, we found that these strategies yield an outperformance without a higher risk. Our results make it hard to maintain the efficient market hypothesis.

Bubbles, Fads and Stock Price Volatility Tests: A Partial Evaluation

This is a summary and interpretation of some of the literature on stock price volatility that was stimulated by Leroy and Porter (1981) and Shiller (1981a). It appears that neither small sample bias, rational bubbles nor some standard models for expected returns adequately explain stock price volatility. This suggests a role for some nonstandard models for expected returns. One possibility is models in which noise trading by naive investors is important. At present, however, there is little direct evidence that such fads play a significant role in stock price determination.

Bubbles, Fads and Stock Price Volatility Tests: A Partial Evaluation

ABSTRACTThis is a summary and interpretation of some of the literature on stock price volatility that was stimulated by Leroy and Porter [28] and Shiller [40]. It appears that neither small‐sample bias, rational bubbles nor some standard models for expected returns adequately explain stock price volatility. This suggests a role for some nonstandard models for expected returns. One possibility is a “fads” model in which noise trading by naive investors is important. At present, however, there is little direct evidence that such fads play a significant role in stock price determination.

Regulatory structure in futures markets: Jurisdictional competition between the sec, the cftc, and other agencies

This paper studies competition among alternative regulatory bodies for authority over innovative financial contracts. In the United States, this rivalry embraces not only the Commodity Futures Trading Commission and the Securities and Exchange Commission, but state and federal deposit-institution regulators and various private regulatory cooperatives. From a political perspective, multipleregulators develop as a way of formally providing ongoing protection for the interests of diverse political constituencies. But from an economic perspective,competition resulting from overlaps in regulatory responsibility establishes an evolutionary mechanism for adapting regulatory structures to technological and regulation-induced innovation. Using both perspectives, this paper explains how interaction between governmental regulatory agencies and self-regulatory cooperatives produces more-efficient regulatory structures over time.The study also seeks to catalog the particular costs and benefits that may be associated with the regulatory tools used to control futures and securities markets(e.g., broker and trader registration, disclosure requirements, margin requirements,and contract-approval processes) and with changes in the distribution of jurisdiction over these tools. The analysis seeks to clarify the tradeoff between the perceived probability of various problems of market performance (e.g., contract nonperformance, widespread financial instability, and activities such as price manipulation by which corrupt or sophisticated operators separate naive investors from their wealth) and the implicit and explicit cost of reducing this probability.