Knowledge that Transforms

We investigate the way investors react to prior gains/losses. We directly examine investor reactions to different definitions of gains and losses (i.e., overall wealth, paper gains and losses, and realized capital gains and losses) and investigate how gains and losses in one category of wealth (e.g., real estate) affect holdings in other categories (e.g., financial assets). We show that investors change their holdings of risky assets as a function of both financial and real estate gains. Prior gains increase risk-taking, while prior losses reduce it. To interpret our results, we consider and compare three alternative hypotheses of investor behavior: prospect theory, house money effect and standard utility theory with decreasing risk aversion. Our evidence fails to support loss aversion, pointing in the direction of the house money effect or standard utility theory. Investors consider wealth in its entirety, and risk-taking in financial markets is affected by gains/losses in overall wealth, financial wealth, and real estate wealth.

Combining survey responses and trading records of clients of a German retail broker, this paper examines some of the causes for the apparent failure to buy and hold a well-diversified portfolio. The subjective investor attributes gleaned from the survey help explain the variation in actual portfolio and trading choices. Self-reported risk aversion is the single most important determinant of both portfolio diversification and turnover; other things equal, investors who report being more risk tolerant hold less diversified portfolios and trade more aggressively. Less experienced investors similarly tend to churn poorly diversified portfolios. The effect of perceived knowledge on portfolio choice is less clear cut; holding other attributes constant, investors who think themselves knowledgeable about financial securities indeed hold better diversified portfolios, but those who think themselves more knowledgeable than the average investor churn their portfolios more.

We use a unique data set to study how U.K. banks deal with financially distressed small and medium-sized companies under a ‘contractualist’ bankruptcy system. Unlike in the U.S., these procedures limit the discretion of courts to strict enforcement of debt contracts, without any dilution of creditors’ claims. We show that lenders and borrowers select a debt structure that avoids some of the market failures often attributed to a contractualist system. Collateral and liquidation rights are highly concentrated in the hands of the main bank, giving it a dominant position in restructuring or liquidating a defaulting firm. There is little litigation, and no evidence of co-ordination failures or creditors’ runs. However, there is some evidence that the bank’s dominance makes it ‘lazy’ in monitoring, relying heavily on the value of its collateral in timing the bankruptcy decision.

This paper investigates the forecasting accuracy of bankruptcy hazard rate models for U.S. companies over the time period 1962–1999 using both yearly and monthly observation intervals. The contribution of this paper is multiple-fold. One, using an expanded bankruptcy database we validate the superior forecasting performance of Shumway's (2001) model as opposed to Altman (1968) and Zmijewski (1984). Two, we demonstrate the importance of including industry effects in hazard rate estimation. Industry groupings are shown to significantly affect both the intercept and slope coefficients in the forecasting equations. Three, we extend the hazard rate model to apply to financial firms and monthly observation intervals. Due to data limitations, most of the existing literature employs only yearly observations. We show that bankruptcy prediction is markedly improved using monthly observation intervals. Fourth, consistent with the notion of market efficiency with respect to publicly available information, we demonstrate that accounting variables add little predictive power when market variables are already included in the bankruptcy model.

Mergers and acquisitions improve market efficiency by capturing synergies between firms. But takeovers also impose externalities (both positive and negative) on the remaining firms in the industry. This paper describes a new equilibrium concept designed to explain and predict takeovers in this setting. We experimentally compare the new equilibrium concept to that of competing con-cepts in situations without and with externalities. Moreover, we examine the predicted dynamics of takeovers and outcome implications of those dynamics. Our experimental results support the predictions of the new equilibrium concept and provide implications for further empirical tests. 1.

The paper analyses the relationship between deposit insurance, debt-holder monitoring, and risk taking. In a stylised banking model we show that deposit insurance may reduce moral hazard, if deposit insurance credibly leaves out non-deposit creditors. Testing the model using EU bank level data yields evidence consistent with the model, suggesting that explicit deposit insurance may serve as a commitment device to limit the safety net and permit monitoring by uninsured subordinated debt holders. We further find that credible limits to the safety net reduce risk taking of smaller banks with low charter values and sizeable subordinated debt shares only. However, we also find that the introduction of explicit deposit insurance tends to increase the share of insured deposits in banks' liabilities.

Participants in 401(k) retirement plans violate the basic principle of diversification by investing significant fractions of their savings in their employers' equity. This paper characterizes investors' active changes to their company stock investment over time by analyzing new inflows and transfers. The average investor seems to base active changes on salient information, paying attention to past returns, volatility, and business performance. Past returns, over a three-year horizon, predict higher inflow allocations and transfers, whereas volatility and business performance only have a weak effect. The sensitivity to past returns is asymmetric, with investors reacting more strongly to positive and above-S&P500 returns.

Mergers and acquisitions improve market efficiency by capturing synergies between firms. But takeovers also impose externalities (both positive and negative) on the remaining firms in the industry. This paper describes a new equilibrium concept designed to explain and predict takeovers in this setting. We experimentally compare the new equilibrium concept to that of competing concepts in situations without and with externalities. Moreover, we examine the predicted dynamics of takeovers and outcome implications of those dynamics. Our experimental results support the predictions of the new equilibrium concept and provide implications for further empirical tests.

I conduct a time-series analysis of corporate payout policies that accounts for the dynamic nature of these decisions and for the interaction among investment decisions and payout policies. The estimation is done with a VAR model of investments, earnings, total payout, and the split of the total payout between dividends and share repurchases. I control for changes in the legal treatment of share repurchases in 1982 and for changes in the relative taxation of dividends and capital gains. I find that: (i) an increase in the taxation of capital gains relative to dividends shifts the split of total payout away from share repurchase and toward dividends; (ii) corporate investment decisions lead payout policies and not the other way around; (iii) increases in corporate total payout are associated with long-term subsequent increases in earnings; (iv) changes in the composition of corporate payout away from share repurchases and toward dividends are associated with subsequent increases in earnings.