Knowledge that Transforms

ABSTRACT Value stocks have higher returns than growth stocks in markets around the world. For the period 1975 through 1995, the difference between the average returns on global portfolios of high and low book‐to‐market stocks is 7.68 percent per year, and value stocks outperform growth stocks in twelve of thirteen major markets. An international capital asset pricing model cannot explain the value premium, but a two‐factor model that includes a risk factor for relative distress captures the value premium in international returns.

We investigate how differences in legal and financial systems affect firms' use of external financing to fund growth. We show that in countries whose legal systems score high on an efficiency index, a greater proportion of firms use long‐term external financing. An active, though not necessarily large, stock market and a large banking sector are also associated with externally financed firm growth. The increased reliance on external financing occurs in part because established firms in countries with well‐functioning institutions have lower profit rates. Government subsidies to industry do not increase the proportion of firms relying on external financing.

Issuers of initial public offerings (IPOs) can report earnings in excess of cash flows by taking positive accruals. This paper provides evidence that issuers with unusually high accruals in the IPO year experience poor stock return performance in the three years thereafter. IPO issuers in the most “aggressive” quartile of earnings managers have a three‐year aftermarket stock return of approximately 20 percent less than IPO issuers in the most “conservative” quartile. They also issue about 20 percent fewer seasoned equity offerings. These differences are statistically and economically significant in a variety of specifications.

This paper studies the flows of funds into and out of equity mutual funds. Consumers base their fund purchase decisions on prior performance information, but do so asymmetrically, investing disproportionately more in funds that performed very well the prior period. Search costs seem to be an important determinant of fund flows. High performance appears to be most salient for funds that exert higher marketing effort, as measured by higher fees. Flows are directly related to the size of the fund's complex as well as the current media attention received by the fund, which lower consumers' search costs.

ABSTRACT I test the disposition effect, the tendency of investors to hold losing investments too long and sell winning investments too soon, by analyzing trading records for 10,000 accounts at a large discount brokerage house. These investors demonstrate a strong preference for realizing winners rather than losers. Their behavior does not appear to be motivated by a desire to rebalance portfolios, or to avoid the higher trading costs of low priced stocks. Nor is it justified by subsequent portfolio performance. For taxable investments, it is suboptimal and leads to lower after‐tax returns. Tax‐motivated selling is most evident in December.

ABSTRACT We propose a theory of securities market under‐ and overreactions based on two well‐known psychological biases: investor overconfidence about the precision of private information; and biased self‐attribution, which causes asymmetric shifts in investors' confidence as a function of their investment outcomes. We show that overconfidence implies negative long‐lag autocorrelations, excess volatility, and, when managerial actions are correlated with stock mispricing, public‐event‐based return predictability. Biased self‐attribution adds positive short‐lag autocorrelations (“momentum”), short‐run earnings “drift,” but negative correlation between future returns and long‐term past stock market and accounting performance. The theory also offers several untested implications and implications for corporate financial policy.