University Of Amsterdam Faculty of Economics & Business MSc: Finance Master Thesis Contrarian investing & investor attention Tom Hayje 10025332 July 2015 Supervisor: Philippe Versijp 1 Statement of Originality This document is written by Student Tom Hayje who declares to take full responsibility for the contents of this document. I declare that the text and the work presented in this document is original and that no sources other than those mentioned in the text and its references have been used in creating it. The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents. 2 Table of content 1. Introduction 3 2. Literature review 5 3. Data & Methodology 10 3.1 Data 10 3.2 Methodology 10 3.2.1 Portfolio formation process. 10 3.2.2 Attention proxies 11 4. Empirical results 13 4.1 Regular contrarian strategy 13 4.2 Abnormal trade volume strategy 14 4.3 Convexity and concavity of price patterns strategy 18 4.4 Extreme returns strategy 22 4.5 Results summarized 26 5. Conclusion 27 6. References 29 7. Appendix 31 3 1. Introduction In certain financial theoretical frameworks and models, such as the capital asset pricing model, the agents involved and the asset prices set by these agents are assumed to be rational (Fama, 2003). In most financial contexts rationality is defined as: Investors update their beliefs correctly upon receiving news and they base their choices on maximizing their utility (Barberis, 2003). However, since there are still several phenomena in the financial markets which cannot be explained by the financial theories and models (Hirshleifer, 1998) it might be that perhaps in practice there it is not so easy to decide for individual investors about which actions are considered the most rational actions, and that in practice there are no perfectly rational investors (Hirshleifer, 2001). This approach to financial theory, in which not all agents are assumed to be fully rational, is referred to as behavioral finance (Barberis 2003) and it is a relatively new field of finance. In recent years behavioral finance has been used to research new problems in the financial markets and to provide a fresh perspective for older problems. Behavioral finance has been used to research a vast range of subjects; from trying to find out if investors trade too much ,what kind of stocks they trade to how individual investors react to news regarding the stock they are paying attention to. In this paper behavioral finance will also be used to tackle a relatively older financial phenomenon: The returns earned by contrarian investment strategies. To be more specific: the effect investor attention has on contrarian investment returns. Contrarian investing is an investment strategy in which the investors buys the stocks that have the relatively worst past performance and sells the stocks that have the relatively best past performance. Contrarian investing has been shown to regularly generate abnormal returns over the long term (Addea- Dappaah, 2009). These abnormal returns are an anomaly in the finance field since it uses past prices to predict future prices, which should not be possible according to the weak form of the efficient market hypothesis (Fama, 1965), and these returns should also eventually be corrected by arbitrage (Chen, 2014). Contrarian investing also works in markets beside, the American financial markets, so it can be ruled out that institutional factors are causing these returns (Schierek, 1999). Investor attention is the particular behavioral aspect that is going to be used for this research. De Bondt & Thaler theorize that one potential explanatory factor for the abnormal contrarian returns are investors “overreacting” to news and dramatic events (De Bondt, 1985). Two papers regarding investor attention have recently been published (Barber, 2008) Chen, 2014). In the first of these two papers the authors concluded that investors generally tend to buy relatively more of the stocks that have caught their attention in some way (Barber, 2008). The other paper stated that investors cannot react to stocks that they are not paying attention to, and thus cannot overreact to news and events regarding these stocks (Chen, 2014). Thus, if overreactions are the cause for the excess returns earned by contrarian investing then most likely this overreaction effect will be stronger for stocks that receive a lot of attention since, as said before, investors generally purchase more stocks that have grabbed their attention. The theorized overreaction effect will also be smaller for the stocks that receive less attention, or those that nobody pays attention to. This particular subject is relevant because it researches a relatively older financial problem using a more recent theoretical approach. Only a few years ago the first paper dealing with the effect of investor attention on momentum investing was published, while the momentum investing phenomena has been around almost as long as contrarian investing. This research is also original because there currently are no papers combining the two subjects of contrarian investing and investor attention. 4 The aim of this thesis is thus to research if investor attention has a significant effect on contrarian investing. The research question that needs to be answered is: Does investor attention have a significant effect on the returns of contrarian investing? To try and answer this question the thesis is set up as follows: First there will be a brief literature review in section two. After which the data used and methodology are described in section three. This section is followed by section four, which contains the empirical results from the tests performed. The paper ends with a quick summary of the entire paper and an answer to the research question, and suggestions for future research. 5 2. Literature review In this section the most relevant papers that are used for this thesis research and are referenced throughout this paper are outlined briefly. The paragraph starts off with a brief review of some of the contrarian and investor attention research done so far. This is followed by a discussion of the results and conclusions from each paper. After which the papers their contribution to this research is explained. Theoretical foundations One of the earliest papers on contrarian investing was published in 1985 and was written by De Bondt and Thaler. Although the word contrarian is not used in this paper the research tests the performance of buying the stocks that have performed the worst and selling the stocks that have performed the best, which is the main principle that contrarian investing is based on. The paper proposes that because not all investors are rational, investors will not update their beliefs according to Bayes’ rules and thus will potentially overreact to certain events. The paper then goes on to state that if stock prices tend to systematically overshoot then the reversals of these prices should be predictable using past data (De Bondt, 1985). To test their theory De Bondt & Thaler introduce two hypotheses: Extreme movements in stock prices will be followed by subsequent price movements in the opposite direction, and the more extreme the initial price movement, the greater will be the subsequent adjustment. Weak market efficiency is violated if either one of these hypotheses turns out to be true (De Bondt, 1985). To test whether these two hypotheses hold, the authors construct portfolios based on the past performance from the NYSE stocks between January 1926 and December 1982. These stocks are sorted based on their past excess returns, the top and bottom stocks are then put into “winners” and “losers” portfolios respectively. The average cumulative abnormal return (CAR) is then calculated for all the portfolios. If the two proposed hypotheses are true then the CAR from the loser’s portfolio minus the CAR from the winner’s portfolio should be above zero. (De Bondt, 1985) Since the abnormal returns that could potentially be achieved by de Bondt & Thaler’s strategy are in violation of the weak efficient market hypothesis (Fama, 1965) the contrarian strategy was going to be tested repeatedly under varying circumstances in order to determine the actual validity of these returns. One of these tests was done by Chan (Chan, 1988). Chan proposed that the returns from contrarian investing were not caused by an overreaction, but that the risks of the winner and loser stocks are not constant over time and if not accounted for causes measurement errors in the betas and could affect the estimation of the abnormal returns (Chen, 1988). After controlling for these possible risk changes and measurement errors, Chan concludes that the abnormal returns earned by contrarian investing are not as significant, and finds no evidence in support of market overreaction (Chan, 1988). A few years later however, the contrarian method was tested again by Lakonishok, Schleifer and Vishny (Lakonishok, 1994). Their research shows that contrarian investing significantly outperforms the market which is caused by investor behavior and not because the strategy is fundamentally riskier of a mismeasurement of risk (Lakonishok, 1994). The authors theorize that loser stocks outperform the winner stock because investors underestimate the future growth rates of loser stocks compared to the growth rates of winners stocks. 15 years later De Bondt again researches contrarian investing strategies, but this time the setting is the German stock market. Contrarian and momentum investment strategies are tested in the Frankfurt stock 6 exchange to test whether or not the results from previous research that was done in the American stock market were caused by institutional factors or a mismeasurement of risk (Schierek, 1999) This paper uses a similar method of constructing the loser and winner portfolios as the previous paper, with stocks being sorted based on the past excess returns over a certain period.