Jekyll2024-02-09T11:31:11-08:00https://christophmerkle.github.io/feed.xmlChristoph MerkleAssociate Professor of FinanceProf. Dr. Christoph Merklecmerkle@econ.au.dkValue and Momentum from the Perspective of Financial Professionals2022-01-28T00:00:00-08:002022-01-28T00:00:00-08:00https://christophmerkle.github.io/posts/ValMom<p><i>This is an English version of a research summary posted by <a href="https://www.dvfa.de/fileadmin/downloads/Verband/Studien_Umfragen/Value_und_Momentum_aus_der_Sicht_von_Finanzprofis.pdf"><b>DFVA</b></a> (Association of Investment Professionals in Germany) based on our research paper “Value and Momentum from Investors’ Perspective: Evidence from Professionals’ Risk-Ratings” by Christoph Merkle and Christoph Sextroh, 2021, Journal of Empirical Finance, 62, 159-178.</i></p>
<p>Value and momentum remain among the most popular investment styles among professional investors and fund managers. Historically, these strategies have performed very well, even if there are temporary setbacks now and then. Given this performance, the question is whether value and momentum strategies are associated with increased risk. Financial theory traditionally assumes that higher returns do not come without higher risk. A whole series of theoretical models and empirical tests therefore attempt to establish a link between value, momentum, and risk.</p>
<p>We have approached this question from a different direction and invited finance professionals to participate in an online experiment via the CFA Institute and DVFA. We wanted to know how the risk assessments of these investors depend on various key figures of the companies to be evaluated. The design used is relatively simple: Based on seven key figures, two companies are compared with each other. These include the market-to-book ratio and the P/E ratio as measures of value, as well as the excess return relative to the market over the last twelve months as a measure of momentum. The participants are then asked to assess which of the two company shares they consider riskier. We do not want to know what the investors have learned in their studies or in their CFA courses, but how they assess real risk on financial markets. For some of the company pairs we also ask about expected return, as not everyone may have the historical returns of these investment styles in mind or believe that they will continue in the future.</p>
<p>Our findings are clear. Professional financial market participants see both value and momentum stocks as less risky. Participants are skeptical when they observe a high market valuation, which is expressed in a higher P/E ratio or a higher market-to-book ratio. They may consider it uncertain whether this valuation is justified and associate higher risk with these stocks. High past returns, on the other hand, do not scare investors. Rather, it is companies with negative return trends that are seen as riskier. At the same time, we can confirm that participants interpret traditional risk measures such as volatility and beta as risky. In this respect, the results for value and momentum are embedded in a risk assessment that is otherwise in line with financial theory.</p>
<p>Nevertheless, the results naturally pose a problem for financial theory. Are there relatively safe stocks with strong returns that can easily be identified based on simple ratios? Convinced value and momentum investors will claim just that, but this opinion cannot be mainstream, otherwise all investors would flock to this segment and drive prices up. It is therefore worthwhile to consider return expectations. In fact, participants expect a positive return of the last twelve months to continue at least over the next twelve months. Momentum therefore promises high returns with modest risk from the perspective of financial professionals. The results for Value are somewhat more mixed. Shares with a low P/E ratio are seen as likely to outperform in the future, but this does not apply to shares with a low market-to-book ratio.</p>
<p>Overall, the impression of professional investors seems to be that value and momentum are not risk factors but anomalies. Consequently, the efficient market theory does not rank very highly among the participants when asked which financial market models they consider valid. Factor models and valuation based on multiples enjoy a much higher reputation.</p>Prof. Dr. Christoph Merklecmerkle@econ.au.dkThis is an English version of a research summary posted by DFVA (Association of Investment Professionals in Germany) based on our research paper “Value and Momentum from Investors’ Perspective: Evidence from Professionals’ Risk-Ratings” by Christoph Merkle and Christoph Sextroh, 2021, Journal of Empirical Finance, 62, 159-178.Mental Accounts and Investor Behavior2021-11-08T00:00:00-08:002021-11-08T00:00:00-08:00https://christophmerkle.github.io/posts/MAcc<p><i>This is an English version of a research summary to appear in <a href="https://schmalenbach-impulse.de/mentale-konten-und-anlegerverhalten/"><b>Schmalenbach IMPULSE</b></a> based on our research paper “Closing a mental account: the realization effect for gains and losses” by Christoph Merkle, Jan Müller-Dethard and Martin Weber, 2021, Experimental Economics, 24, 303–329.</i></p>
<p>Most investors remember exactly at which price they bought a stock and follow the further price development relative to this price. Such behavior can be well described by the concept of “mental accounting”, investors open a mental account for each individual investment and register profits and losses on this account. Many online brokers support this type of accounting and prominently display the return since purchase, often in green and red for positive and negative price movements. Would the annual return be a more reasonable metric, the Sharpe Ratio, or aggregate portfolio-level results? Perhaps, but the desire to keep track of the entire history of an investment seems strong.</p>
<p>How do mental accounts affect risk-taking behavior? The evidence on this seems contradictory. On the one hand, there is the example of the casino visitor who willingly puts winnings back on the line because he feels he is not playing with his own money but with casino money (“house money”). On the other hand, we know about investors that the desire to take profits and thus reduce risk increases when an investment is on the plus side. This behavior can be replicated in a simple laboratory experiment. Participants are given 2 euros and can bet any portion of it on the outcome of a dice roll. If the die shows the participant’s lucky number, the stake is returned sevenfold. We are interested in the behavior of the winners after they have won such a prize. Do they become more conservative or more daring?
It depends! The decisive factor is whether further rounds of the experiment will follow seamlessly, or whether an interruption will be made and the winnings are paid out. In the first case, the profit is a paper gain, as it is also typical in financial investments. The final word on the outcome has not yet been spoken. In this situation, winners tend to be more risk-seeking, as the paper winnings serve as a buffer for them. In this way, smaller losses can be endured without ending the game in the red. Similar, by the way, with losses. As long as there is still the possibility to recover prior losses, participants try to break even by increasing the risk. The interim payout of the earned amounts fundamentally changes this behavior. If another game is now offered, winners and losers are significantly more risk-averse.</p>
<p>The theory of mental accounting helps to understand this change of mind. At the start of the experiment, a mental account is opened that moves into the gain or loss domain over the course of the dice rounds. This perception causes a risk adjustment with the goal of finishing in the gain domain. Interruption of the game with payoff of the earned amounts results in the closing of the mental account. Similar to an investor selling a stock, paper profits are realized and recorded as final. A round of dice that now follows is no longer part of the original game and is considered separately from it. A participant no longer has a cushion of paper wins to absorb potential losses. Consequently, participants who have already recorded a win are less likely to try their luck again. Likewise, a realized profit in an investment gives a good feeling that one does not want to gamble away again so quickly. Likewise, after realized losses, closing the mental account leads to lower risk appetite. Participants can no longer balance the account and are disinclined to repeat the unpleasant experience. In extreme cases, this leads investors to withdraw from the stock market altogether after stock market crashes. As statistics from the Deutsches Aktieninstitut show, investor numbers regularly collapse after drastic market declines (DAI 2021).</p>
<p>The finding that risk behavior reverses as the mental account closes is described by the term realization effect (Imas, 2016). We want to know how universal this effect is and show in a series of further experiments that the skewness of the underlying distribution of a gamble, has a significant impact on the realization effect. In statistics, skewness describes the type and strength of asymmetry of a distribution.</p>
<p>If, as described at the outset, participants can invest in a game of chance that has a small chance of producing a large win and otherwise a small loss (positive skewness), the described realization effect emerges: higher risk propensity after unrealized outcomes. This difference disappears when the gamble offers a large chance of a small win or a 50:50 chance of a medium-sized win (negative skewness or symmetric distribution). In these cases, participants do not take an increased risk after either a paper win or a paper loss, and the realization effect disappears.</p>
<p>The reason for this is not that the expected value of gambling differs across experiments (it remains constant). Rather, the distributions without positive skewness do not have the attractive properties that induce risk-taking. For example, a small win is often not enough to provide a cushion against possible losses. Since participants tend to bet at most their paper profit, their options are severely limited with puny profits. In the loss area, the break-even point becomes a distant prospect if the amount of the potential profit only slightly exceeds the stake.</p>
<p>In real financial markets, therefore, the broadly diversified fund investor is not likely to suddenly become exuberant after moderate paper gains. The distribution of returns simply does not allow for this. The situation is different for investors in so-called lottery stocks. These often inexpensive and highly volatile securities are characterized by positive skewness. They are popular with retail investors and encourage them to increase their risk as long as existing gain or loss positions are not realized.</p>
<p><i>References</i><br />
Deutsches Aktieninstitut (DAI). 2021. Deutschland und die Aktie – Eine neue Liebesgeschichte?
www.dai.de/fileadmin/user_upload/210225_Aktionaerszahlen_2020.pdf (accessed 01.11.2021)<br />
Imas, Alex. 2016. “The Realization Effect: Risk-Taking after Realized versus Paper Losses.” American Economic Review, 106 (8): 2086-2109.</p>Prof. Dr. Christoph Merklecmerkle@econ.au.dkThis is an English version of a research summary to appear in Schmalenbach IMPULSE based on our research paper “Closing a mental account: the realization effect for gains and losses” by Christoph Merkle, Jan Müller-Dethard and Martin Weber, 2021, Experimental Economics, 24, 303–329.Financial Loss Aversion Illusion2019-03-06T00:00:00-08:002019-03-06T00:00:00-08:00https://christophmerkle.github.io/posts/FLAI<p><i>This is a brief non-technical summary of my forthcoming article in the <b>Review of Finance</b>.</i></p>
<p>Most people dislike losses much more than they like gains of equal size, a feature of human preferences known as loss aversion. It has been frequently documented in psychology and economics, with the conclusion that losses loom larger than gains by a factor of about two. In finance, loss aversion is suggested to explain, for instance, the equity premium puzzle (“Why are stock returns so high?”) and stock market participation (“Why do so few people invest in stocks?”).</p>
<p>In the evaluation of gains and losses, one has to distinguish between anticipated and experienced outcomes. Most scientific experiments use gambles or lotteries which focus on the trade-off between anticipated gains and losses. However, this implies that people are able to forecast the hedonic impact of gains and losses with great accuracy. In contrast, recent evidence suggests that people’s ability to cope with losses is much better than they predict.</p>
<p>Using a unique dataset, I tests this proposition in the financial domain. In a panel survey of retail investors from a large bank in the UK, participants state how they feel about anticipated and experienced returns in their investment portfolios. In a time period of frequent losses and gains in the stock market (2008-2010), I examine how their ratings relate to the magnitude of portfolio gains and losses.</p>
<p>The results demonstrate that loss aversion is strong for anticipated outcomes, for which I obtain a loss aversion coefficient of about 2.2. This means that investors react twice as much to negative expected returns as compared to positive expected returns. However, when evaluating experienced returns, the loss aversion coefficient decreases to about 1.2. Investors are not more sensitive to losses than to gains when they are reflecting about their past portfolio performance. The loss aversion they show ex ante seems to be partly or fully an affective forecasting error.</p>
<p><img src="/images/Loss Aversion.jpg" /></p>
<p>The findings have practical implications for investing behavior. While loss aversion is a legitimate part of people’s preferences, the documented <i>financial loss aversion illusion</i> represents an inconsistency in how a loss is viewed at different points in time. If investors systematically overestimate their personal loss aversion when thinking about financial outcomes, their investment decisions will differ from what is justified by their actual experiences. In particular, they will invest in less risky assets than would be optimal from an ex post perspective and will avoid potential losses unless they receive a substantial compensation. Indeed, investors with less risky portfolios in terms of volatility or assets are found to be more loss averse. However, this higher loss aversion is not backed by their loss experience as they do not react differently to losses compared to investors who bear higher portfolio risk.</p>Prof. Dr. Christoph Merklecmerkle@econ.au.dkThis is a brief non-technical summary of my forthcoming article in the Review of Finance.