Decision Quality Blog

The foundation to behavioral economics is the idea that investors are not rational actors: That they overreact to uncertainty, are influenced by immaterial information, and act for all manner of reasons not consistent with their best interests (utility). I found a paper the other day published by The Paul Woolley Centre for the Study of Capital Market Dysfunctionality called How Do Investors React Under Uncertainty? that reinforces this point.  Here’s a clip from the conclusion:

It is proposed that uncertainty, rather than risk, provides a much more realistic representation of the setting that we face when we come to pricing asset, and particularly corporate equities. We have gone a long way down the path of developing pricing models that incorporate risk (e.g. CAPM, APT, Fama and French empirical three-factor model) but comparatively little work has been done on the role (if any) that uncertainty plays in asset pricing. In order for uncertainly to affect pricing, it must have some influence on how investors incorporate information into pricing. Our contribution is to evaluate whether uncertainty influences the way by which investors respond to earnings announcements which will provide us with valuable insights as to the role that uncertainty plays in asset pricing.

In particular, we evaluate the proposition that investors will follow maxmin expected utility and so will progressively overweight bad news and underweight good news as they become more uncertain. Using VIX as a proxy for market uncertainty and earnings announcements as our information signal, we find that there is an asymmetric response to good and bad earnings news at high levels of uncertainty which is consistent with uncertainty breeding pessimism in the minds of investors. However, we do find evidence to suggest investors might have a more optimistic bent than is allowed under maxmin expected utility as indicated by how they react to earnings announcements when uncertainty is at the lower end of the scale.