Knowledge that Transforms

We employ a novel brokerage account data set to investigate which individual investors are the most attentive, how investors allocate their attention, and the relation between investor attention and performance. Attention is positively related to investment performance, at both the portfolio return level and the individual trades level. We provide evidence that the superior performance of high-attention investors arises because they purchase attentiongrabbing stocks whose positive performance persists for up to six months. Finally, we show that paying attention is particularly profitable when trading stocks with high uncertainty, but for which a lot of public information is available. (

We use a unique data set from a large retail bank containing internal managerial Accounting data on revenues and costs per client to analyze how banks and their financial advisors generate profits with customers. We find that advised transactions are associated with higher profits than independently executed trades of the same client. The bank’s own mutual funds and structured products are most profitable for the bank, and profits increase with trade size. We show that advisors recommend exactly those transactions. Furthermore, we find that advised clients achieve a worse performance than independent clients, suggesting that advisors put their employer’s interest first.

Firms move between growth and value because of changes in either size or book value of equity. The value premium is specific to variation in book-to-market that emanates from size changes. A factor based on this variation earns the entire value premium; one based on the remaining variation earns no premium. Hence, not all high book-to-market firms earn the value premium, and some low book-to-market firms earn value-like returns. Many models price portfolios sorted by size and book-to-market. None distinguish firms that earn the value premium from those that have a high book-to-market but do not earn the premium.

We study whether stocks are riskier or safer in the long run from the perspective of Bayesian investors who employ the long-run risk, habit formation, or prospect theory models to form prior beliefs about return dynamics. Economic theory delivers important guidance for long-run investment opportunities. Specifically, incorporating prior information from the habit formation or prospect theory models reinforces beliefs in mean reversion and inferences that stocks are safer over longer horizons. Conversely, investors with long-run risk priors perceive weaker mean reversion and riskier equities. Model-based information is particularly important for inferences about uncertainty in the dividend growth component of returns.

I study the driving forces behind dividend smoothing by developing a dynamic agency model in which dividends signal the earnings persistence of firms. In equilibrium, managers treat dividends and earnings as informational substitutes. They smooth dividends relative to earnings to smooth negative news releases and lower their turnover risk. Empirical estimates of the model parameters imply that 39% of observed dividend smoothness among U.S. firms is driven by managers’ own career concerns, not shareholders’ preferences. Managers cut investments and adjust external financing policies to accommodate this career-concern-based dividend smoothing. These effects lead to a 2% decline in firm value. Received May 28, 2016; editorial decision September 13, 2017 by Editor David Denis.

In the aftermath of the financial crisis, institutions have been asked to reduce leverage in order to reduce risk. To address the effectiveness of this measure, we build a model of equity volatility that accounts for leverage. Our approach blends Merton’s insights on capital structure with traditional time-series models of volatility. We estimate that precautionary capital needs for the entire financial sector reached $2 trillion during the crisis. We also investigate the long-standing observation that equity volatility asymmetrically responds to positive and negative news. Volatility asymmetry is mostly explained by exposure to the aggregate market, not a mechanical leverage effect.

How reliable is the recovery theorem of Ross (2015)? We explore this question in the context of options on the 30-year Treasury bond futures, allowing us to deduce restrictions that link the physical and risk-neutral return distributions. Our empirical results undermine the implications of the recovery theorem. First, we reject an implicit assumption of the recovery theorem that the martingale component of the stochastic discount factor is identical to unity. Second, we consider the restrictions between the physical and risk-neutral return moments when the recovery theorem holds, and reject them in both forecasting regressions and generalized method of moments estimations.

We propose a novel approach to measuring long-run returns to mergers. In a new data set of close bidding contests we use losers‘ post-merger performance to construct the counterfactual performance of winners had they not won the contest. Stock returns of winners and losers closely track each other over the 36 months before the merger, and bidders are also very similar in terms of Tobin’s Q, profitability and other accounting measures. Over the three years after the merger, however, losers outperform winners by 24 percent (14 percent internationally). Commonly used methodologies such as announcement returns fail to identify acquirors‘ underperformance.

Most firms deleverage from their historical peak market-leverage (ML) ratios to near-zero ML, while also markedly increasing cash balances to high levels. Among 4, 476 nonfinancial firms with five or more years of post-peak data, median ML is 0.543 at the peak and 0.026 at the later trough, with a six-year median time from peak to trough and with debt repayment and earnings retention accounting for 93.7% of the median peak-to-trough decline in ML. The findings support theories in which firms deleverage to restore ample financial flexibility and are difficult to reconcile with most firms having materially positive leverage targets. Received November 17, 2016; editorial decision November 9, 2017 by Editor David Denis.

When students fund their education through loans, changes in student borrowing and tuition are interlinked. Higher tuition costs raise loan demand, but loan supply also affects equilibrium tuition costs - for example, by relaxing students' funding constraints. To resolve this simultaneity problem, we exploit detailed student-level financial data and changes in federal student aid programs to identify the impact of increased student loan funding on tuition. We find that institutions more exposed to changes in the subsidized federal loan program increased their tuition disproportionately around these policy changes, with a sizable pass-through effect on tuition of about 65 percent. We also find that Pell Grant aid and the unsubsidized federal loan program have pass-through effects on tuition, although these are economically and statistically not as strong. The subsidized loan effect on tuition is most pronounced for expensive, private institutions that are somewhat, but not among the most, selective.