Juhani T. Linnainmaa
Associate Professor of Finance
NBER Faculty Research Fellow
5807 South Woodlawn Avenue
Chicago, IL 60637
Email: jlinnain [at] chicagobooth.edu
Tel: +1 (773) 834 3176
Individual investors lose money around earnings announcements, experience poor post-trade returns, exhibit the disposition effect, and make contrarian trades. Using simulations and trading records of all individual investors in Finland, I find that these trading patterns can be explained in large part by investors' use of limit orders. These patterns arise mechanically because limit orders are price-contingent and suffer from adverse selection. Reverse causality from behavioral biases to order choices does not appear to explain my findings. I propose a simple method for measuring a data set's susceptibility to this limit order effect.
Award: Best finance paper 2010 award from the Foundation for the Advancement of Finnish Securities Market.
Featured in the Chicago Booth Capital Ideas (October 2007) and the Economist Intelligence Unit.
Classical approaches to estimation and decisions requiring estimation often are at odds. When values critical to the decision are convex or concave functions of unknown parameters, the statistician’s estimation error adjustments are the opposite of what is appropriate for the decision. We illustrate the conflict by studying multi-period investment problems. The proper application of Jensen’s inequality to the decision turns finance intuition on its head: multi-period investments with negative risk premia can be profitable, risk-averse investors can have infinite demand for risky securities, settings exist in which risk-averse investors should not diversify, and demand for mutual funds with negative alphas may be rational.
When agents can learn about their abilities as active investors, they rationally "trade to learn" even if they expect to lose from active investing. The model used to develop this insight draws conclusions that are consistent with empirical study of household trading behavior: Households' portfolios underperform passive investments; their trading intensity depends on past performance, and they begin by trading small sums of money. Using household data from Finland, the paper estimates a structural model of learning and trading. The estimated model shows that investors trade to learn even if they are pessimistic about their abilities as traders. It also demonstrates that realized returns are significantly downward-biased measures of investors' true abilities.
Award: One of five papers awarded the "best finance papers of 2011" award by the Foundation for the Advancement of Finnish Securities Market.
Stock market participation is monotonically related to IQ, controlling for wealth, income, age, and other demographic and occupational information. The high correlation between IQ, measured early in adult life, and participation, exists even among the affluent. Supplemental data from siblings, studied with an instrumental variables approach and regressions that control for family effects, demonstrate that IQ’s influence on participation extends to females and does not arise from omitted familial and non-familial variables. High-IQ investors are more likely to hold mutual funds and larger numbers of stocks, experience lower risk, and earn higher Sharpe ratios. We discuss implications for policy and finance research.
Featured in Bloomberg Businessweek ("Smart Money Owns More Equities Says IQ Study of Who Buys Stocks," January 19, 2012) and New York Times ("What High-I.Q. Investors Do Differently," February 26, 2012)
Award: One of five papers awarded the "best finance papers of 2011" award by the Foundation for the Advancement of Finnish Securities Market.
We analyze whether IQ influences trading behavior, performance, and transaction costs. The analysis combines equity return, trade, and limit order book data with two decades of scores from an intelligence test administered to nearly every Finnish male of draft age. Controlling for a variety of factors, we find that high-IQ investors are less subject to the disposition effect, more aggressive about tax-loss trading, and more likely to supply liquidity when stocks experience a one-month high. High-IQ investors also exhibit superior market timing, stock-picking skill, and trade execution.
Award: Runner-up for Goldman Sachs International - Best Conference Paper Award at the 2010 European Finance Association Conference.
This paper investigates the information content of signals about the identity of investors and whether they affect price formation. We use a dataset from Finland that combines information about the identity of investors with complete order flow records. While we document that investors use multiple brokers, our study demonstrates that broker identity can nonetheless be used as a powerful signal about the identity of investors who initiate trades. This finding testifies to the existence of frictions in the economic environment that prevent investors from completely eliminating the information content of broker ID using mixed strategies. We show that the broker ID signal is important enough to affect prices: The permanent price impact of orders coming from different brokers fits the information profile of the investors associated with these brokers. Our results suggest that the market correctly processes the signal embedded in broker identity, and liquidity improvements documented in the literature when exchanges adopt a more anonymous market structure could arise because prices adjust less efficiently to order flow information when the degree of anonymity increases.
This paper shows individuals’ product market choices influence their investment decisions. Using microdata from the brokerage and automotive industries, we find a strong positive relation between customer relationship, ownership of a company, and size of the ownership stake. Investors also are more likely to purchase and less likely to sell shares of companies they frequent as customers. These effects are stronger for individuals with longer customer relationships. A merger-based natural experiment supports a causal interpretation of our results. We find weaker causality in the other direction: inheritances and gifts of stocks have only a modest effect on individuals’ patronage decisions. A setup in which customer-investors regard stocks as consumption goods, not just as investments, seems to best explain our results.
Mutual funds often disappear following poor performance. When this poor performance is partly attributable to negative idiosyncratic shocks, funds' estimated alphas understate their true alphas. This paper estimates a structural model to correct for this bias. Although most funds still have negative alphas, they are not nearly as low as those suggested by the fund-by-fund regressions. Approximately 12% of funds have net four-factor model alphas greater than 2% per year. All studies that run fund-by-fund regressions to draw inferences about the prevalence of skill among mutual fund managers are subject to reverse survivorship bias.
Daniel and Titman (2006) propose that the value premium is due to investors overreacting to in- tangible information. They therefore decompose five-year changes in firms' book-to-market ratios into stock returns and a residual that is a proxy for tangible information based on accounting performance ("book returns"). Consistent with investors overreacting to intangible information, they find that only stock returns orthogonal to book returns reverse. We show that their decomposition creates a book return polluted by past book-to-market ratios, stock returns, net issuances, and dividends. Empirically, two-fifths of the variation in book returns is due to these factors. In addition, the Daniel and Titman (2006) result is sensitive to methodological choices. When we use the change in the book value of equity as a proxy for tangible information, only the tangible component of stock returns reverses. Moreover, current book-to-market subsumes the intangible return's power to predict the cross-section of average returns, which casts doubt on the argument that book-to-market forecasts returns because it is a good proxy for the intangible return.
Gross profit scaled by book value of total assets predicts the cross-section of average returns. Novy-Marx (2013) concludes that it outperforms other measures of profitability such as bottom-line net income, cash flows, and dividends. One potential explanation for the measure's predictive ability is that its numerator—gross profit—is a "cleaner" measure of economic profitability. An alternative explanation lies in the measure's deflator. We find that net income equals gross profit in predictive power when they have consistent deflators. Deflating profit by the book value of total assets results in a variable that is the product of profitability and the ratio of the market value of equity to the book value of total assets, which is priced. We then construct an alternative measure of profitability, operating profitability, which better matches current expenses with current revenue. This measure exhibits a far stronger link with expected returns than either net income or gross profit. It predicts returns as far as ten years ahead, seemingly inconsistent with irrational pricing explanations.
We examine the performance and holdings of 2,818 asset managers who market over 44,000 investment products, representing $35 trillion in assets under management as of 2012. In aggregate, investors paid $267 billion in fees to asset managers in 2011, comprising the second largest securities investing component of Philippon's (2013) cost of financial intermediation. On a net return basis, asset managers break even relative to strategy benchmarks, and outperform by 1% relative to asset class benchmarks. Performance is not random across asset managers. Boutique managers demonstrate security selection skill. Consistent with Berk and Green (2004), gross performance is positively correlated with fees. We also find that the relation between idiosyncratic performance and asset flows attenuates in manager size, suggesting that large asset managers ameliorate their clients' career concerns.
Using unique data on Canadian households, we assess financial advisors' impact on their clients' investment portfolios. We find that advisors induce their clients to take more risk, thereby raising clients' expected investment returns. On the other hand, we find limited evidence that advisors personalize their recommendations: advisors direct clients into similar portfolios independent of their clients' risk preferences and stage in the life cycle. An advisor's own portfolio is a good predictor of what type of portfolios his or her clients hold even after controlling for investor attributes. This one-size-fits-all advice does not come cheap. The value-weighted client portfolio lags passive benchmarks by more than 2.5% per year net of fees, which suggests that the average investor gives up all of the equity premium gained through increased risk-taking.
A strategy that selects stocks based on their historical same-calendar month returns earns an average return of 13% per year. We develop and test two models to evaluate the source of these profits. In the first model the seasonalities arise from seasonal variation in the risk premia of common factors; in the second they are stock-specific. Our empirical results are consistent with the first model: common factors account for at least three-quarters of the seasonalities in individual stock returns, exposing seasonal investment strategies to systematic risk. The factors are largely the same as those driving the differences in average returns.
Size and book-to-market split into two components, one correlated with changes in market value and the other with everything else. Only the market value components have positive risk premia. Average returns are flat across portfolios based on the other parts, but their loadings on SMB and HML differ significantly. This mismatch between covariances and average returns generates significant alphas for high-minus-low portfolios. The estimated fraction of skilled fund managers increases from 4% to 18% when we control for the other parts. Also, the other part of value drives the negative correlation between gross profitability and value.
Award: Second prize in the academic competition at the Chicago Quantitative Alliance (CQA) Fall 2012 Conference.
This paper argues that an absence of serial correlation in forecast errors is not the appropriate benchmark for rational analyst behavior. We put forward a model that confronts analysts with two layers of uncertainty. An initial layer of uncertainty about firm-specific parameters leads analysts to underreact to signals from some firms and overreact to signals from others. A subsequent layer of uncertainty about the distributions from which these firm-specific parameters are drawn causes the null hypothesis of serially uncorrelated forecast errors to be frequently rejected despite being true. We then test our learning model’s predictions using IBES data, finding support for the view that analysts learn about individual firms in the face of time-varying model uncertainty.
This paper examines the impact of trading constraints on market participation when agents learn about their investment opportunities. The possibility of facing binding constraints in the future creates a feedback that can keep agents out of the market even if the risk premium is high. This effect arises with learning because the changes in investment opportunities are correlated with future realized outcomes: an agent will have a poor investment opportunity set precisely in those future states where her marginal utility is high. Non-participation arises also in an equilibrium model where agents resolve uncertainty about the cash flow covariance between tradable and non-tradable assets. These results suggest that learning and short-sale constraints can simultaneously generate limited participation, higher risk premium, and insignificant contemporaneous correlation between the stock return and the income of those who do not participate in the stock market. We conclude that a standard intertemporal hedging motive, generated by (i) learning about the parameters of the economy or by (ii) changes in the labor income dynamics, may account for agents' seemingly puzzling nonparticipation decisions without relying on non-standard preferences.
This paper shows that individual day traders are reluctant to close losing day trades. They even sell other stocks from their portfolios to finance the unintended purchases. This disposition to ride losers has significant long-term welfare consequences. Day traders hurt their portfolios’ performance up to −6% in three months after a holdings change. The changes in individuals’ exposure to market-wide shocks cause this underperformance: individuals systematically migrate towards small technology stocks with low B/M ratios. We find a negative relation between day trading profits and long-term performance: active day traders have the highest day trading profits but they hurt their long-term performance the most. Our results suggest that behavioral biases can push investors towards portfolios they might feel uncomfortable holding under other circumstances.
Updated: October 8, 2014