Research Highlights - February 2018

Comments Off on Research Highlights - February 2018
Research Highlights - February 2018 LoadingADD TO FAVORITES

An array of new research by economist Nicola Gennaioli and colleagues helps explain why contrarian investors outperform those who follow the herd.  Specifically, the best way to gain excess-returns turns out to be investing in the shares least favored by analysts.  The research shows that during the last thirty-five years, investing in the 10 percent of U.S. stocks about which analysts were most optimistic would have yielded on average 3 percent a year.  By contrast, investing in the 10 percent of stocks about which analysts were most pessimistic would have yielded an amazing 15 percent a year.  For comparison’s sake those who owned the S&P 500 index over those thirty-five years would have earned 11.4 percent a year.

Gennaioli and colleagues shed light on this paradox with the help of cognitive sciences and, in particular, using Kahneman and Tversky’s concept of representativeness. Decision makers, according to this view, overweight the representative features of a group or a phenomenon.  These are defined as the features that occur more frequently in that group than in a baseline reference group.

After observing strong earnings growth — the explanation goes — analysts think that the firm may be the next Google.  “Googles” are in fact more frequent among firms experiencing strong growth, which makes them representative.  The problem is that “Googles” are very rare in absolute terms.  As a result, expectations become too optimistic, and future performance disappoints.  A model of stock prices in which investor beliefs follow this logic can account both qualitatively and quantitatively for the beliefs of analysts and the dynamics of stock returns.

In related work, the authors show that the same model can account for booms and bust in the volume of credit and interest rate spreads.

These works are part a research project financed by the European Research Council aimed at taking robust insights from cognitive sciences and at incorporating them into economic models.  Kahneman and Tversky’s concept of representativeness lies at the heart of this effort, as well.

“In a classical example, we tend to think of Irishmen as redheads because red hair is much more frequent among...

To continue reading, become a paid subscriber for full access.
Already a Business Briefings subscriber? Login for full access now.

Subscribe for as low as $135/year

  • Get 12 months of Business Briefings that will impact your business and your life
  • Gain access to the entire Business Briefings Research Library
  • Optional Business Briefings monthly CDs in addition to your On-Line access
  • If you do not like what you see, you can cancel anytime and receive a 100% pro-rata refund