Investor Behavior Over Business Cycles With Tacit And Endogenous Market Signals
Shanghai University of Finance and Economics – Institute of Accounting and Finance
Hong Kong University of Science & Technology (HKUST) – Department of Economics
What can past market crashes teach us about the current one?
Investors often behave in puzzling ways. In this paper, we develop a theory that implies “unusual” investor behaviors in a market equilibrium with heterogeneous investors who formulate their investment strategies based on their individual assessments of market signals, where market signals are tacit information and endogenously dependent on the individual assessments. Tacit information requires experience and knowledge to interpret and understand. We find that (1) differences in investors’ knowledge, experience, risk attitudes and incomes can give rise to “unusual” investor behaviors under economic rationality; (2) investor behaviors are normal in normal periods, but abnormal in abnormal periods (a reversal of investor behaviors) when a swing market drives many inexperienced and highly risk-averse investors in and out of the market; (3) a change in the population shares of different types of investors in the market can cause a reversal of investor behaviors among those same types of investors; and (4) empirical evidence clearly supports our theory.
Investor Behavior Over Business Cycles with Tacit and Endogenous Market Signals – Introduction
The behaviors of investors can sometimes be quite puzzling indeed. In this paper, we offer a theory to explain some of those puzzling investor behaviors based on economic rationality instead of a behavioral approach. The unique feature of our model is that investors rely on market signals to assess the investment environment, but the market signals are conversely endogenously dependent on the investors’ assessment; however, since the market signals are tacit information, the investors’ interpretation of the market signals is dependent on their abilities and different investors have different abilities. We show theoretically and empirically that “unusual” investor behaviors can occur in this setting.
Tacit information requires time, effort and experience to learn how to utilize it. For example, swimming takes a lot of practice to master; it cannot be learned by reading swimming materials only. Similarly, for average investors, it would take years of experience to learn to utilize market signals. We propose a formulation of expectation under tacit information based on the Bayesian approach. The key in our formulation is that the investors’ expectations are unbiased, but the variance of this expectation depends on an investor’s ability/experience.
Specifically, in a model with a riskfree asset and a risky asset, unusual investor behaviors are when: (1) a less knowledgeable investor invests more in risky assets than a more knowledgeable investor does; (2) a more risk-averse investor invests more in risky assets than a less risk-averse investor does; and (3) a poorer investor invests more in risky assets than a richer investor does. We show that these behavioral “abnormalities” can arise when the population share of those investors who are less knowledgeable, more risk averse or poorer is relatively large. The message we bring is that with endogenous and tacit market signals, the unusual investor behaviors are in fact rational in certain circumstances.
With tacit information, investors differ in their experience, ability and knowledge in interpreting market signals. Consequently, an uneven population distribution of various types of investors drives our conclusions. Population sizes can deepen or diminish the effect of market signals. The over-reactions or under-reactions of a particular type of investors when a behavioral reversal occurs are crucially dependent on the population sizes of different types of investors. A behavioral reversal in our model is caused by an over-reaction of the type of investors that form a large proportion of the overall population coupled with an under-reaction of the type of investors that form a small proportion of the overall population. The intuition of our results is clear. If one investor is considering investing in a risky asset after observing a positive signal, then all investors of the same type would be considering the same. With an endogenous public signal, more investment strengthens the public signal. By this equilibrium process, a positive signal is always boosted by investors of the type that make up a large share of the population but dampened by investors of the type that make up a small share of the population. The end result is a behavioral reversal depending on which type of investors is dominant in the overall population. In sum, since we have an endogenous market signal (the strength of which is dependent on the reactions to it), with tacit information, differences in risk aversion, income distribution and the ability to interpret public signals due to the differences in experience and knowledge among investors can lead to the so-called unusual investor behaviors in equilibrium.
We test our theory using data from venture capital (VC) investments. We find strong empirical support for our theory. Specifically, we find normal investor behaviors among different groups of investors in normal periods, but a reversal of investor behaviors (abnormal behaviors) among those same groups of investors in abnormal periods when a swing market drives many inexperienced and highly risk-averse investors in and out of the market. We also find that a change in the population shares of different types of investors in the market can cause a reversal of investor behaviors among those same types of investors.
This paper proceeds as follows. Section 2 provides a literature review. Section 3 presents the model. Section 4 offers theoretical analysis. Section 5 provides empirical analysis. Section 6 concludes the paper.
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