Can the Market Multiply and Divide? Non-Proportional Thinking in Financial Markets

68 Pages Posted: 26 Mar 2018 Last revised: 2 Aug 2019

See all articles by Kelly Shue

Kelly Shue

Yale School of Management; National Bureau of Economic Research (NBER)

Richard Townsend

University of California, San Diego (UCSD) - Rady School of Management

Multiple version iconThere are 2 versions of this paper

Date Written: April 6, 2019

Abstract

Nominal stock prices are arbitrary. Therefore, when evaluating how a piece of news should affect the price of a stock, rational investors should think in percentage rather than dollar terms. However, dollar price changes are ubiquitously reported and discussed. This may both cause and reflect a tendency of investors to think about the impact of news in dollar terms, leading to more extreme return responses to news for lower-priced stocks. We find a number of results consistent with such non-proportional thinking. First, lower-priced stocks have higher total volatility, idiosyncratic volatility, and market betas, after controlling flexibly for size. To identify a causal effect of price, we show that volatility increases sharply following pre-announced stock splits and drops following reverse stock splits. The returns of lower-priced stocks also respond more strongly to firm-specific news events, all else equal. The economic magnitudes are large: a doubling in a stock's nominal price is associated with a 20-30% decline in its volatility, beta, and return response to firm-specific news. These patterns are not exclusive to small, illiquid stocks; they hold even among the largest stocks. Non-proportional thinking can explain a variety of asset pricing anomalies such as long-run and short-run reversals, as well as the negative relation between past returns and volatility (i.e., the leverage effect). Our analysis also shows that the well-documented negative relation between risk (volatility or beta) and size is actually driven by nominal prices rather than fundamentals.

Keywords: Non-Proportional Thinking, Nominal Prices, Leverage Effect, Volatility, Underreaction, Overreaction

Suggested Citation

Shue, Kelly and Townsend, Richard, Can the Market Multiply and Divide? Non-Proportional Thinking in Financial Markets (April 6, 2019). 9th Miami Behavioral Finance Conference 2018, Yale ICF Working Paper No. 2018-08, Available at SSRN: https://ssrn.com/abstract=3148311 or http://dx.doi.org/10.2139/ssrn.3148311

Kelly Shue (Contact Author)

Yale School of Management ( email )

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National Bureau of Economic Research (NBER) ( email )

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Richard Townsend

University of California, San Diego (UCSD) - Rady School of Management ( email )

9500 Gilman Drive
Rady School of Management
La Jolla, CA 92093
United States

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