At Harbert: Research
Liz Wang Associate Professor Department of Finance
Behavior Bias Plays Underappreciated Role In Investing
I n her research, Liz Wang , an associate professor in the Department of Finance, explores the significance of investors’ behavioral bias, sometimes defined as irrational beliefs or practices that influence decision-making. “If investors have a better understanding of the factors that drive stock returns, it will help them make better decisions,” she said of papers she has published in the Journal of Financial Economics and other journals. “Let’s say we know that investors have a behavior bias that will lead to a certain kind of stock being systematically underpriced. Then we can buy that underpriced stock and make a profit in the future, when the stock value goes back to the fundamental value.” She says that finding structures that drive stock returns will potentially lead to better investment strategies. The traditional theory of personal investing posits that investors are more rational, using all the information they have available to analyze the stock in order to make wise decisions. But Wang and other like-minded researchers have noted that often the prediction resulting from this framework differs significantly from what can be observed in market data. “From the psychology perspective, we know in essence they’re all human beings,” Wang said. “They have all
different kinds of behavior bias which deviates from the assumptions in the classic traditional model, and these psychological factors affect stock returns in several ways.” The bulk of Wang’s research is based on prospect theory, a framework proposed by Nobel Prize-winning psychologist Daniel Kahneman. Prospect theory, also known as loss- aversion theory, focuses on the way investors value gains and losses. The theory says that investors consistently place more weight on perceived gains versus perceived losses. When investors are presented with two equal choices, they will choose the one that’s presented in terms of potential gains. With this theory as a basis, Wang’s research seeks to find a realistic method of understanding what drives the way people invest — a method that results in a more realistic picture of investor behavior than what has previously been observed in the market. One of her papers explores the performance of lottery-like stocks — stocks with such amazing returns that investing in them seems like winning the lottery. Tesla, for example, is often referred to as a lottery stock. With these stocks, people who put in small amounts of money early on may see returns of 1,000% or more. You take a low-risk chance, wait a while, then bring home the big money.
Wang’s findings show demand for these lottery stocks is strongest in a five-day window ahead of a company’s earnings announcements, which leads to a price run-up. At this point, these stocks outperform others by about 52 points. But five days after earnings announcements, the pattern reverses. Conversely, her examination showed a pronounced negative risk-return relation among firms in which investors had prior losses, again emphasizing the influence of behavioral bias.
Harbert Business, Fall 2022 11
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