Knowledge that Transforms

The positive relationship between money flows into investment products and their return performance is an important market indicator for market practitioners and academics. This article studies the impact that active versus passive investment styles have on this relationship. We further evaluate the effects of a passive approach in two crucial stages: portfolio selection and asset allocation. We find that a passive investment style in either stage weakens the relationship between flows and returns compared with an active style. However, the investment style in the asset allocation stage has a greater effect than in the portfolio selection stage, on the relationship between flows and returns.

Investors do not hold optimal portfolios. We use an experimental method to isolate factors that compel individuals to hold optimal portfolios. Our design includes two risky assets with perfectly negatively correlated payoffs so that all risk can be eliminated. We find that participants’ holdings approach optimal portfolios only under very specific conditions: the variance cost of holding an imbalanced portfolio is substantial and feedback on period-by-period outcomes is suppressed (eliminating the impact of cognitive biases resulting from misperceptions of randomness).

This article estimates the effects of Say-on-Pay (SoP), a policy that increases shareholder “voice” by providing shareholders with a regular vote on executive pay. We apply a regression discontinuity design to the votes on shareholder-sponsored SoP proposals. Adopting SoP leads to large increases in market value (5%) and to improvements in long-term profitability. In contrast, it has limited effects on pay levels and structure. Taken together our results suggest that SoP can be seen as a repeated regular vote of confidence on the CEO and that it serves as a disciplining device.

Anecdotal and indirect empirical evidence suggest that excitement and market bubbles are intertwined, such that excitement not only arises during bubbles but may also help fuel them. We directly test the impact of excitement on bubbles in a bubble-prone experimental asset-pricing market ( Capinalp, Porter, and Smith, 2001 ). Prior to trading, participants are assigned to emotion inductions through video clips The results of fifty-five markets show larger asset pricing bubbles in magnitude and amplitude in the excitement treatment relative to a treatment of same valence and lower intensity ( calm ) and a treatment of similar intensity and opposite valence ( fear ).

We exploit the domestic portfolios of US mutual funds to provide microeconomic evidence that investors are more likely to liquidate geographically remote investments at times of high aggregate market volatility. This has important implications for asset prices. The valuations of stocks with ex ante less local ownership decline more when aggregate market volatility is high. Furthermore, the returns of stocks with geographically distant owners are more exposed to changes in aggregate market volatility.

We present a real options model of a firm’s make-or-buy decision under demand uncertainty. “Making” is subject to decreasing returns to scale, fixed costs, and capital investment. “Buying” happens at a fixed price and requires no investment. Three distinct procurement regimes endogenously arise: buying, making, or concurrent sourcing for, respectively, low, intermediate, and high demand. Capital constraints encourage buying or concurrent sourcing. Operating leverage peaks when the firm switches between buying and making, and it is lowest (and negative) at the switch between making and concurrent sourcing. This non-monotonic pattern mirrors and drives the behavior of the firm’s beta.

Policyholder exercise behavior presents an important risk factor for pricing Variable Annuities. However, approaches presented in the literature—building on value-maximizing strategies akin to pricing American options—do not square with observed price and exercise patterns for popular withdrawal guarantees. We show that including taxes into the valuation closes this gap between theory and practice. In particular, we develop a subjective risk-neutral valuation methodology that takes into consideration differences in the tax structure between investment opportunities. We demonstrate that accounting for tax advantages significantly affects the value of the guarantees and produces results that are in line with empirical patterns.

We show that social capital improves the viability of stakeholder-oriented firms operating in competitive markets. Studying exits from the population of Norwegian savings banks after deregulations, we find that banks located in communities with high social capital have a higher probability of survival, but no similar effect exists for commercial banks. Norwegian savings banks are collectively governed by their stakeholders and we provide evidence that social capital improves the efficiency of stakeholder governance. In high social capital areas, banks raise more deposits locally, distribute more of their surplus for altruistic purposes, and operate more locally focused branch networks.

We study approximately 5.0 million stock picks submitted by individual users to the “CAPS” website run by the Motley Fool company (www.caps.fool.com). These picks prove to be surprisingly informative about future stock prices. Shorting stocks with a disproportionate number of negative picks and buying stocks with a disproportionate number of positive picks yields a return of over 12% per annum over the sample period. Negative picks mostly drive these results; they strongly predict future stock price declines. Returns to positive picks are statistically indistinguishable from the market. A Fama–French decomposition suggests that stock-picking rather than style factors largely produced these results.

We show that firms’ R&D activities can predict the stock returns of their industry peers. When an industry experiences substantial R&D growth driven by the activities of a small group of firms, industry peers experience positive abnormal returns and abnormal operating performance despite having no aggressive R&D growth. Exogenous industry shocks to demand or productivity do not explain these results. Further, abnormal returns are concentrated in peer firms that receive low investor attention.