Can We Always Invest Like Mr. Spock, and Not Homer Simpson?

[This is another of a series of editorials by Executive Editor Andrew Karolyi at the Review of Financial Studies featuring recently published papers at the journal. This editorial features “Confusion of Confusions: A Test of the Disposition Effect and Momentum” by The Ohio State University’s Justin Birru, an article in Issue 28(7) for July 2015. It was selected as an Editor’s Choice article on the Oxford University Press web site for RFS.]

Readers may recognize from my title the symbolism of investing like Mr. Spock versus Homer Simpson from the popular book by Cass Sunstein and Dick Thaler, Nudge (Penguin Books, 2009). In it, they describe how investors’ frequent lapses in judgment combined with herd mentality can reveal their inner “Homers” as opposed to choices of efficient-market-stleonard-nimoy-393861_640-pixabayyle “Econs” in the image of Mr. Spock from Star Trek. An April article in Barron’s featuring Thaler (designed to draw attention to his newest book, Misbehaving, May 2015, Norton) got my attention, particularly the discussion around one of the most common Homerian “D’ohs,” the disposition phenomenon. Per prospect theory, recall how people are more risk averse in the domain of stock gains than in the domain of stock losses where they are more risk-seeking, so they tend to hold to losers too long. [Yes, yes, I know that there is hardly a consensus in our literature on whether prospect theory actually predicts the disposition effect, thanks to Barberis and Xiong, Ben-David and Hirshleifer, and others.] The Barron’s article goes on to describe investment strategies at Thaler’s investment firm, Fuller & Thaler, and at JPMorgan’s $2 billion Undiscovered Managers Behavioral Value fund, all designed to capitalize on the disposition effect and other investor cognitive biases.

For such investors, the new article by Justin Birru of The Ohio State University in the July 2015 issue may offer a sobering reality check. The study uses investor-level data to re-examine the disposition effect specifically around a stock split. It’s an intriguing stock event that can serve as an optical illusion. Consider an example. For a stock undergoing a 3-for-2 stock split, an investor with an original purchase price of $20 should now realize that a stock price of $14 actually represents a gain rather than a loss, as the new reference price should be $13.33. What Birru finds is that the disposition effect breaks down following a stock split. In the period after a stock split, investors no longer realize gains at a rate any different than their losses – the winner/loser status of the stock is no longer significant for the selling decision. He suggests a bunch of candidate explanations. Maybe investors are inattentive to the split? Maybe they are unable or unwilling to properly update their reference price? Birru admitted to me in private communication that his paper never offers up a definitive answer here.

But that is just fine. Because this temporary breakdown provides a unique laboratory in which to investigate how and whether the disposition effect induces return predictability. That is the secret code that the Mr. Spock managers are trying to crack! Birru has the findings of prior studies looking at how the disposition effect can explain the momentum anomaly in his sights. Theory predicts that prices will revert to fundamental values in the absence of the disposition effect, so this should lead to a dissipation of momentum returns. It turns out that the momentum anomaly is alive and well in the post-split sample of stocks. He operationalizes the tests using a stock-specific capital gains variable built prior to the split event, which he uses to gauge whether the stock is above or below its fundamental value and with which he predicts their returns post-split.

What are the big picture takeaways? Birru writes to me that investors’ no longer behaving according to the disposition effect following a split is interesting in and of itself. But what he views as more important is that the setting can be exploited to shed light on the relationship between momentum and the disposition effect. Good to know this cognitive bias cannot be the primary driver of momentum returns. Maybe his effort will prompt scholars to explore other corporate events or capital market settings salient for other behavioral biases and the large array of anomalies to be pursued. One thing for sure is that Birru’s work will be a useful caution for our Mr. Spocks out there who seek to capitalize on the vulnerable Homer Simpsons.

Associate Editor Changes

Beginning today, July 1, RFS welcomes the following Associate Editors: Hui Chen, Todd Gormley, Zhiguo He, Gerard Hoberg, Victoria Ivashina, Dirk Jenter, Amiyatosh Purnanandam, and Paul Tetlock.

We thank our retiring Associate Editors: Peter Christoffersen, Mariassunta Giannetti, Eitan Goldman, John Griffin, Wei Jiang, Simi Kedia, and Berk Sensoy.

Editor’s Choice: July

The Editor’s Choice article for July 2015 (issue 28/7) is “Confusion of Confusions: A Test of the Disposition Effect and Momentum” by Justin Birru. You can read the article free online here.

Change to Submission Fees and Referee Payments

The fee for submitting to an SFS journal (RAPS, RCFS, or RFS) will be increasing on July 1, 2015. The new submission fee will be $240 for members and $300 for nonmembers.

Accordingly, we’ll also be increasing our referee payments. The new referee payment for an on-time report will be $200, beginning July 1.

Winners of the RFS Awards

The winners of the RFS Awards were announced at the Awards Reception on Tuesday, May 19, at the SFS Finance Cavalcade Conference. We are pleased to now share the winners:

Distinguished Referee Award 
Zhi Da, Doron Levit, Andrey Malenko, Gregory Nini, Adi Sunderam, Sheri Tice, and Liyan Yang

Michael J. Brennan Best Paper Award
“High-Frequency Trading and Price Discovery” by Jonathan Brogaard, Terrence Hendershott, and Ryan Riordan
Prize: $20,000

Michael J. Brennan Best Paper Runner Up
“Financial Market Dislocations” by Paolo Pasquariello
Prize: $5000

Referee of the Year 
Paolo Pasquariello
Prize: $1000

Rising Scholar Award 
“Capital Account Opening and Wage Inequality” by Mauricio Larrain
Prize: $5000

Congratulations to all our award winners!

For past award history, please visit our Awards page.

LaTeX Style Files Now Available

We are happy to announce that our publisher has made LaTeX style files available to help authors format their papers according to RFS style. You can reach the files on our publisher’s web site or on our web site under Accepted Papers. Please note: these files are for formatting your accepted paper. When submitting a paper, you will still need to follow the guidelines for submissions.

Please contact Jaclyn with any feedback regarding the new files.

Non-Marketable Assets and Capital Market Equilibrium – Redux

[This is another of a series of editorials by Executive Editor Andrew Karolyi at the Review of Financial Studies featuring recently published papers at the journal. This editorial features “Human Capital as an Asset Class Implications from a General Equilibrium Model” by Vanderbilt University’s Miguel Palacios. This paper is from Issue 28 (4) for April 2015. It was selected as an Editor’s Choice article on Oxford University Press web site for RFS.]

As young graduate students at the University of Chicago in the 1980s, I and my colleagues were strongly encouraged (compelled!) in Professor Eugene Fama’s asset-pricing course to read an article by David Mayers published in 1972. It was Dave’s thesis paper and was one of the contributions to the celebrated edited volume by Michael Jensen (Studies in the Theory of Capital Markets) that inspired a lot of modern finance. This excellent paper extended the classic CAPM model of capital market equilibrium of Sharpe (1964), Lintner (1965), Black (1972), and others to include nonmarketable assets such as human capital. The model adapted the expected return-risk relationship to redefine the benchmark model to include all marketable assets as well as the total payoff (income) on all non-marketable assets. And, of course, covariance risks – yes, now two – were accordingly redefined. The concept seemed very intuitive, but yet never really seemed to gain much traction in the empirical testing that followed. I was fortunate to be hired as a young assistant professor at Ohio State where Dave served as a senior colleague and I asked him once why the idea never gained more attention. The turning point, he argued, may have been a seminal 1977 study by Fama and Bill Schwert that collected income data from the U.S. Department of Commerce and that tested for – and comfortably rejected – the need for this extension for the cross-section of U.S. returns.

A number of years later, it seems Dave Mayers’ early work inspired another young graduate student at UC Berkeley, Miguel Palacios, who was intrigued enough (unlike yours truly!) to pursue the question further. And thank goodness for that–the fruits of his labor is celebrated in the form of a very nice contribution to the Review in its April 2015 issue. In the paper, Miguel derives the value and risk of aggregate human capital in a stochastic equilibrium model with Duffie-Epstein preferences (the continuous-time analogue of the more familiar Epstein-Zin preferences). Besides human capital’s value and risk, out of this comes a three-factor model including the market portfolio, the share of capital (relative to labor) and investment in human capital. The amazing statistic is that, upon calibration, the model estimates human capital to constitute a whopping 93% of aggregate wealth, well above what most previous studies have estimated. A second major finding is that human capital is a relatively safe investment, with attributes more like a bond than a stock. There are nuances about this last finding with respect to the horizon over which one judges it.

entrepreneur-1419389_640-pixabayWhen I called on Miguel to point out the most salient facts that readers should take away from his paper, he offered generously that his is not the first paper to assert the importance of human capital as a fraction of total wealth and that the portfolio choice literature has traditionally assumed human capital is safe. Not even the technique of calibrating a production-based asset-pricing model with an implicit valuation for human capital is novel.  What he argues is new is its focus on human capital in a comprehensive theoretical framework where the main economic factors determining its size and risk are part of the analysis. He sees the potential implications going beyond the identification of a three-factor model or of serving up the potential use of investment in education as a conditional variable in its testing. Focusing attention on the characteristics of the asset is the story of the hour.

I say we should welcome the return of human capital, if it ever left. It fits well with our discipline’s penchant for evaluating alternative multi-factor specifications for pricing, so welcome to the competition, human capital, and good luck to you. To the extent that it reflects back the cumulative investment in education we make (20 years before joining the workforce, 50 years of work after that, a substantial fraction of the population devoted to teaching, etc.), its magnitude may very well be as large as that in physical capital, so we should not ignore it. And, as big as human capital may be in countries like the U.S., I wonder about its potential importance in countries like China, India, Brazil, and other emerging markets around the world.