Knowledge that Transforms

This paper examines the degree of portfolio inefficiency subject to various constraints on portfolio weights. When portfolio weights are unconstrained, the posterior loss in expected return on the NYSE-AMEX market portfolio is over 20% (annualized). In contrast, when portfolio weights are constrained to be nonnegative, the posterior loss in expected return is only about 4% (annualized). In addition, short-sale constraints greatly reduce uncertainty in inferences about portfolio efficiency.

SOES bandits are individual investors who use Nasdaq's Small Order Execution System (SOES) for day trading. Their average profit per trade is small, but they trade dozens or hundreds of times per week. Bandits usually establish a position before most market-makers have updated their quotes, and lay off the position at favorable prices through Instinet or SelectNet. It is noteworthy that they trade profitably with market-makers despite having less information. Bandits keep the profits and bear the losses from their trades. Thus they have greater incentives to trade well than the employees of market-making firms.

Because of its institutional features, the Nasdaq market does not fit the standard competitive model. We construct a model that reflects the distinguishing characteristics of the Nasdaq market. This model implies that in dealer markets with a minimum price increment, competition among market-makers does not necessarily drive spreads down to the level of marginal cost. Using this result, we provide an explanation for the odd-eighth avoidance documented in Christie and Schultz (1994). We show that market-makers can use odd-tick avoidance as a coordination device to increase spreads. Evidence from Nasdaq supports our hypotheses.

We find reliable evidence that both book-to-market (B M) and dividend yield track time-series variation in expected real stock returns over the period 1926 91 (in which B M is stronger) and the subperiod 1941–1991 (in which dividend yield is stronger). A Bayesian bootstrap procedure implies that an investor with prior belief 0.5 that expected returns on the equal-weighted index are never negative comes away from the full-period B/M evidence with posterior probability 0.08 for the hypothesis (0.14 with the impact of the 1933 outlier tempered). Although this raises doubts about market efficiency, the post-1940 evidence is consistent with expected returns always being positive.

We study changes in the real estate industry among organizational forms with varying degrees of restrictiveness and document the associated changes in profitability, free cash flow, debt, dividends, and investment policies. All troubled firms in our sample move to a more flexible organizational structure, with subsequent reductions in dividends, improvements in performance, and increases in asset sales and investments. Healthy firms that move to a tighter structure have larger free cash flows before the change; they increase dividends, reduce free cash flows and improve profitability after the change. We document evidence of tax considerations in organizational changes.

We document extreme bias and dispersion in the small-sample distributions of four standard regression-based tests of the expectations hypothesis of the term structure of interest rates. The biases arise because of the extreme persistence in short interest rates. We derive approximate analytic expressions for the biases under a simple first-order autoregressive data generating process for the short rate. We then conduct Monte Carlo experiments based on a bias-adjusted first-order autoregressive process for the short rate and for a more realistic bias-adjusted VAR-GARCH model incorporating the short rate and three term spreads. Conducting inference with the small-sample distributions of test statistics rather than with their asymptotic distributions provides a more consistent rejection of the expectations hypothesis. Plausible sources of measurement error in short and long yields do not salvage the expectations hypothesis.

This paper examines the ability of naive investor expectations models to explain the higher returns to contrarian investment strategies. Contrary to Lakonishok, Shleifer, and Vishny (1994), we find no systematic evidence that stock prices reflect naive extrapolation of past trends in earnings and sales growth. Building on Bauman and Dowen (1988) and La Porta (1995), however, we find that stock prices appear to naively reflect analysts' biased forecasts of future earnings growth. Further, we find that naive reliance on analysts' forecasts of future earnings growth can explain over half of the higher returns to contrarian investment strategies.

Nasdaq's Small Order Execution System (SOES) allows orders to be submitted by computer, thereby assuring rapid execution at quoted prices. We examine trading in the 20 largest Nasdaq stocks around the time of a rule change that reduced the largest SOES trades from 1000 to 500 shares. We show that SOES trades contain information about short-term price movements and that SOES trading declined dramatically with the rule change. However, quoted and effective spreads were unaffected by the rule change.

This paper examines change in property-liability insurers' risk-taking around enactments of state guaranty fund laws. Our evidence suggests that the risk of insurers' asset portfolios increases following enactments. But this increase in risk is significant only for stock insurers. Our evidence of increased risk-taking following guaranty-fund adoptions suggests that the way these funds are organized creates counterproductive investment incentives, especially for stock companies. Because these laws were enacted by states over the period 1969–1981, our evidence on changes in risk-taking helps resolve statistical problems that have been troublesome for studies of bank deposit insurance.

Our simulation results show that tests for long-horizon (i.e.. multi-year) abnormal security returns around firm-specific events are severely misspecified. The rejection frequencies using parametric tests sometimes exceed 30% when the significance level of the test is 5%. Our results are robust to many different abnormal-return models. Conclusions from long-horizon studies require extreme caution. Nonparametric and bootstrap tests are likely to reduce misspecification.