Behavioral Finance

The following sections are included:

• Dedication
• Preface
• About the Editor
• List of Contributors
• Acknowledgments
• Contents

Prediction markets have been found to provide relatively accurate and inexpensive means for forecasting various events including elections results. However, since in most political elections, there exist public polls that predict the results as well as betting houses that publish odds on the various candidates and since voters obtain information from these sources, the marginal contribution of prediction markets is uncertain and needs to be assessed empirically. In this chapter, we investigate the correlations between poll results and prediction markets results throughout the election campaign in Israel prior to the April 2019 elections and compare their accuracy. We show that although correlated and influenced by the polls, prediction markets have some value. Given their minimal costs of operation, such markets are worthwhile.

We investigate the impact of a new regulation, Amendment 20, on executive compensation in Israel. The Amendment, effective as of 2013, is aimed at controlling rapidly increasing executive compensation, as well as the perceived disconnect between executive pay and firm’s financial performance. The concentrated ownership structure in Israel provides us with the opportunity to examine the value of control as manifested in the implementation of the Amendment. The analysis is conducted using hand-collected data on firms traded on Tel-Aviv Stock Exchange in a 2-year window around 2012, the year in which the Amendment was signed into law. We find evidence that chief executive officers (CEOs) classified as related parties in firm’s annual financial statements are able to impact the structure of their post-amendment compensation. Our evidence is consistent with CEOs who are related parties, compared to CEOs who are not related parties, influencing the design of their compensation so that its bonus component increases, leading to an increase in their total cash compensation. However, we are unable to find evidence that this increase stems from an increase in salary. In this way, companies with influential CEOs seem to shift the composition of pay from cash salaries to cash bonuses in response to the Amendment, visibly complying with the intent of the Amendment, however, leaving the CEO better off. We also find evidence for the ability of powerful chairmen to temper the bonus growth of non-influential CEOs. Last, we find no evidence that equity-based compensation increased, suggesting that the bonding of CEO pay to stock-market performance did not increase.

The massive real-estate price increases experienced in Israel over the last several years have elicited in policymakers the realization that they need to take action to reduce housing demand and prevent the Israeli housing market from collapsing. As a result, during May and October 2010, the Bank of Israel stepped in and increased the effective rate on mortgages and lowered the number of qualified applicants. In announcing the new regulations, the Bank of Israel’s main objective was to halt rising demand and to prevent further growth of the housing bubble. We use event study analysis to show that not only did the new regulations have no effect on housing prices but they in fact also markedly influenced the market value of the real-estate companies traded on the Tel-Aviv stock exchange.

Poor corporate governance facilitates unreliable financial reporting. The AGR governance rating is based on the premise that a more accurate assessment of corporate governance can be formulated by taking this output of corporate governance into account. We document that time series variation in a firm’s AGR rating reliably forecasts measures of firm operating performance. A long/short strategy based on the AGR rating generates a risk-adjusted return of approximately 5% per year but, consistent with learning by the market, this abnormal performance has been declining over time. Most of this return differential originates with firms having poor corporate governance.

This chapter examines the seminal heuristic of anchoring and adjustment and its effects on personal bankruptcy proceedings. Using a unique and detailed database of bankruptcy files we analyze the effect of the official receiver’s recommendation on court decisions. The official receiver in bankruptcy proceedings is appointed by a judicial authority and is required to bring before the court any relevant information needed in order to reach a judicial decision. As part of her responsibilities, the official receiver is required to submit a financial report, which serves as the basis for the court’s proposal for the debtor’s payment plan. This chapter sets out the main factual infrastructure for determining the payment order under bankruptcy proceedings and should include information relevant to the court’s discretion. The richness of the data allows us to investigate the impact of the receiver’s recommendation on court final decisions. We find that overall, the receiver’s recommendation serves as an anchor to the judges, and, moreover, that deviations from this recommendation by the court are extremely rare. Notably, this outcome differs dramatically from that of corporate proceedings. Since personal bankruptcy proceedings do not allow for substantive oversight, which examines the plausibility of the actions or recommendations that the receiver seeks, there is no pure rational explanation for this finding.

In this chapter, I sketch the picture emerging from two studies of mine dealing with psychological aspects of immediate and longer-term stock price reactions to analyst recommendation revisions. These studies demonstrate that: (i) if on the day of a recommendation upgrade (downgrade), the respective stock’s abnormal return is negative (positive), then the stock’s cumulative abnormal returns for the period of up to half a year following the recommendation upgrade (downgrade) tend to be higher (lower), and (ii) cumulative abnormal stock returns during half a year following analyst recommendation upgrades (downgrades) tend to be higher (lower) if the latter are published before holidays. I attribute these findings to the effects of investor inattention to news and mood, respectively.

This chapter analyzes stock return behavior following initial public offering (IPO) events in the pharmaceutical sector and examines factors that could have an impact on this behavior.

The results of the research indicate a positive Cumulative Average Abnormal Return (CAAR) of 3.03% in the 20 days following the IPO until the end of the quiet period for all firms under examination, and a decline of tens of percent in the 18 months post-IPO. When the sample is divided into two subsamples according to firm size, a market value (MV) of US$500 million can be identified as a threshold for positive or negative post-IPO yields. Companies with an MV below this threshold experience a positive but not significant CAAR in the first 20 days post-IPO and a significant negative CAAR from day 31 onwards. In contrast, companies above this US$500 million threshold show a significant positive CAAR 20 days post-IPO, followed by a consistent increase in CAAR for the next few months. The results also indicate that MV, IPO proceeds, shareholder dilution and clinical phases are critical factors determining post-IPO returns. In conclusion, we suggest that investors recognize a US$500 million market value of a firm as a confidence threshold when investing in newly issued pharmaceutical companies. We postulate that firms valued above this amount attract more attention and gain greater investor confidence than do firms below this threshold. Lower-valued firms shares can be considered “lottery stocks,” as their IPO ignites a period of enthusiasm until the quiet period ends, where after investors’ attention to such firms gradually diminishes, and their focus moves on to their next potential lottery-like opportunity.

Earlier studies document positive first-day return for initial public offerings (IPOs), commonly interpreted as underpricing of the issue. The empirical evidence also indicates that IPO underpricing is negatively related to the public float (the fraction of the firm sold to the public). One possible explanation for this relation is that firms allocate a fixed amount of money for underpricing, and set an issue price accordingly — a behavioral characteristic. But, if indeed firms allocate a fixed amount of money to underpricing, then this underpricing should diminish in the public float. Using a sample of IPOs between 1996 and 2008, we provide empirical evidence that indeed the relation between underpricing and the public float is non-linear. Specifically, the higher the public float, the less the decrease of underpricing in the public float. Moreover, in our regression analysis, regressing underpricing on the reciprocal of the public float provides the best fit. As we show, this result is consistent with firms allocating a fixed amount of money for underpricing. This finding is important because it helps predict underpricing and has implications for firms, investors and regulators.

We investigate the relationship between religion and stock market participation. Using data for a representative sample of the Chinese population, we find that compared with non-religious households, Buddhists are more likely to invest in stocks, while Muslims are less likely to invest in stocks. In contrast, the differences in stock market participation between non-religious households and other religious households, such as Taoists, Protestants and Catholics, are statistically insignificant. Furthermore, religiosity is negatively associated with the propensity to invest in stocks. Social attitudes turn out to be helpful in explaining the higher stock market participation of Buddhist households. Instrumental variable estimations show that the effects of being Muslim and Buddhist on stock market participation are likely causal.

Investment beliefs, serving as a bridge between high-level objectives and practical decision-making, are increasingly implemented in the investment industry. The present web-based study compares the beliefs of Swedish professional (N = 64) and non-professional (N = 278) investors, testing the links between investment beliefs and portfolio risk-taking in both samples. The results expose significant differences between the beliefs of professionals and others, also showing that the portfolio risk-taking of non-professionals is susceptible to self-confidence and emotional effects while the professionals respond to investment beliefs and risk attitude. The results confirm that disclosure of investment beliefs may reduce tensions between stakeholders and investment managers for the industry’s benefit.

Previous research examined the causes for suboptimal financial decisions. However, scant research has been devoted to examine the psychological effects of suboptimal financial decisions. This chapter empirically examines the emotional outcomes of pension and provident suboptimal financial decisions. Study 1 reveals that the word pension elicits many negative associations. Study 2 reveals that suboptimal pension and provident decisions lead to greater accessibility of negative thoughts. Moreover, the greater accessibility of negative thoughts following suboptimal financial decisions was found to be more salient among male then female participants. In this chapter, we provide theoretical as well as practical applications of the current findings. We also suggest future research directions that could be conducted to better enable capture this important topic.

Interval forecasting tasks are commonly used to test for forecast-overconfidence. Pointing at deficiencies of the methodology, we advance a modified assignment, where subjects provide point predictions and assess the likelihood of return falling within small intervals around their estimates. The difference between the subjective likelihood assessments and the realized hit rates is advanced as an improved forecast-overprecision measure. Over three incentivized studies, 163 of 195 participants overestimate their hit rates, and a closer look at the data illustrates that inaccuracy and excessive certainty act as distinct sources of overprecision. Applications where the adapted task may prove more powerful than standard interval forecasting are discussed.

The agency paradigm is primarily concerned with compensation contracts that align the interests of top management with those of shareholders, but such alignment may be imperfect. In particular, if shareholders differ in their time-preferences, it will be impossible to find a contract that fully aligns manager interests with those of both long-term and short-term shareholders. In this study, we examine the relationship between the inter-temporal weighting on a CEO’s contract and shareholder welfare in a setting where shareholders liquidate choose to cash in their holdings in different time-periods. We show that the managerial compensation contract will typically create incentives for the manager to trade-off short-term price increases with long-term value creation and it is possible to design a second-best contract that is Pareto optimal. This analysis shows that the impact of earnings management is often mischaracterized as Pareto suboptimal even though it may be a requisite to make both long and short-term shareholders better-off on average.

This chapter examines retirement savings withdrawal preferences in Israel and the psychological and demographic factors that affect them, by questioning recipients in a setting where real-life pension decisions are made. Unlike findings from other countries, most of the participants preferred annuity over a lump sum withdrawal. Lower confidence in the system and higher self-confidence were significantly associated with lump sum withdrawals preference. We suggest that the preference for an annuity stems from a default setting: pension savings in Israel have long been defined benefit (DB), that is, a fixed pension which to the recipient is more similar to an annuitized defined contribution (DC) system than to a lump sum withdrawal.

We examine subjective life expectancy perceptions of Israeli smokers by investigating the results of an online survey of a representative sample of 963 Israeli residents aged 50–70 years. Our results suggest that smokers are overoptimistic regarding their subjective life expectancy, a fact that is expected to influence the decision-making process in general, and financial decisions in particular. Indeed, our results are consistent with the results obtained by Hurwitz and Sade (2019) with regard to annuitization decisions.