Stock Market Expectations and Risk Perception of Professionals: Difference between Asking for Price Levels and Asking for Returns
General, Cognitive and Mathematical Psychology
Final Report Abstract
Prices and returns are interchangeable ways to think about the development of financial assets. Normative decision theory assumes that expectations and decisions are invariant to changes in superficial features of the information and the way they are elicited. But do retail investors understand for instance a chart of a fund's past performance in the same way when presented with past prices and by past returns? Is it the same to ask investors to forecast prices or to forecast returns? In this project we conduct three experimental studies and several supplementary surveys with finance professionals and students to address these questions. Across the studies we vary the level of expertise of the subjects, the amount of information and the incentive schemes. We report sizeable differences in the subjective expectations depending on the chart format and the question format, consistent across all studies: Asking subjects to forecast returns as opposed to price levels results in higher expectations. The scope of the effect varies between 1.1 and 2.4 percentage points per month across studies. In contrast, showing subjects return bar charts as opposed to price level line charts results in lower expectations. Across studies the magnitude of the effect varies between 1.7 and 1.0 percentage points per month. In addition, showing subjects price line charts results in extrapolation of the recent past returns while the more distant past returns tend to be ignored. In contrast, showing subjects return bar charts draws attention to the entire sample of past returns. The effects of the question format and the chart format are stronger for subjects with low Cognitive Reflection Test score. Hence, subjects who are more likely to jump to conclusions are more susceptible to format changes whereas subjects with a higher tendency to reflect upon their judgment are less susceptible to format changes. Our results further suggest that the chart format can contribute to the subjects' understanding of the data. When presented with return bar charts subjects take into account the average past return over the entire period covered by the chart. In contrast, when presented with price line charts, subjects focus exclusively on the most recent observations. Future research could focus on examining the potential of various formats of information presentation to improve investors' understanding in order to prevent systematic mistakes in judgment and decision making. Our results further imply that regulation should address the flexibility of financial advisors and information platforms to endogenously vary superficial features of the decision environment of their clients. By changing the formats of charts and questions a financial advisor can for instance affect the buy/sell decisions or the trading frequency of investors in order to increase profits. Since the susceptibility to format changes is mediated by the involuntary impulses, having financial market experience would not be a useful remedy. Therefore, future research should be devoted to examining potential remedies against subjects' susceptibility to changes in superficial features of the decision environment.
Publications
- (2016) Thinking About Prices Versus Thinking About Returns in Financial Markets, SSRN working paper
Glaser, M., Z. Iliewa and M. Weber
(See online at https://dx.doi.org/10.2139/ssrn.2750064)
