Predictable Behavior, Profits, and Attention

Abstract:     
This paper studies the set of links between a behavioral bias, transitory price movements, and the rational response to the bias. We show that attention-grabbing events lead active individual investors to consider and ultimately buy stocks they have not previously owned. Not all attention-grabbing events lead to predictable behavior. Only those events that lower search costs (i.e., events that narrow the set of stocks under consideration) lead to attention-based buying. We show that attention-based buying is linked to transitory price shocks with a magnitude of 1.29% and duration of 10 days. We also hypothesize and show that behavioral biases do not exist in a vacuum - especially biases that are linked to asset price movements. Rational arbitrageurs (smart traders) profit in response to attention-based buying. The smart traders earn one day profits of 0.76% net of transaction costs. We are able to decompose the smart traders' profits into a portion related to liquidity provision (58%) and a portion related to taking advantage of attention-based buying (42%). Our data and profit decomposition allow us to calculate the substantial economic cost of a behavioral bias borne by individual investors.

Number of Pages in PDF File: 41

Keywords: Attention, statistical arbitrage, behavioral finance

JEL Classification: G14, G15

working papers series