[R-SIG-Finance] self-fulfilling prophecies in financial study

[Richard Herron]

I don't want to argue semantics, but for your examples there is a
real, underlying change.

Inclusion in an index improves liquidity and information production
for the real reasons you discuss (e.g., increased trading by index
funds or an increase in capitalization that added the firm to the
index).

For the size effect the only thing that changed was that some
researchers said "I think that small stocks earn an abnormal return,"
and the effect diminished. I consider this a "prophecy" because there
is no real underlying change, just an idea planted by academic
research.

Richard Herron


On Wed, May 9, 2012 at 10:49 AM, Nitish Ranjan <nitish.ranjan at gmail.com> wrote:
> Disappearance of size effect will not be an example of self fulfilling
> prophesy (it disappeared rather than become stronger).
>
> In the stock market, possible examples are:
>
> 1. Index inclusion effect in returns
> 2. The tendency of traders to put in trades early in the day or later in
> the day but not in the middle of the day.
> 3. Most dispersion in returns during the earnings month.
>
> The second part of the email asked about R code/test which will test these
> effects for self fulfilling prophecy. The null for such test is "Are there
> any economic reasons why we would see self fulfilling prophecies to work."
> A general test is hard (probably impossible, see the following discussion)
> since different economic(or psychological) factors shape each of these
> examples. But we can formulate hypotheses for each one of these examples
> and write tests.
>
> Let me take the example of index inclusion effect. It is well known that
> after included in an index such as S&P 500, a stock performs well. Why? For
> one, there are many funds which are pegged to S&P 500 and many more which
> simply follow the index. Both these kind of funds will have demand for the
> newly inducted stock. Both these kind of funds will begin to buy the stock
> and
> move the prices up for the newly inducted stock. Since neither of these
> demands have any informational origins, we would expect the permanent
> impact to be small (close to zero) and a large temporary impact. See the
> survey paper http://www4.ncsu.edu/~rswarr/fm2006.pdf for further discussion.
>
> Another channel via which the effect might play out is through new
> information production. It is very possible that index inclusion actually
> brings a stock to the forefront of investors and produces new research for
> the stock which in turn should make the stock less volatile. A
> Campbell-Schiller type decomposition might help with matters here. You
> could also examine the actual production of information (number of news
> articles, analyst following, analyst dispersion etc). This line of
> reasoning suggests that we would see this effect most for stocks which come
> from relative anonymity to being famous. We would observe less of this
> effect for stocks which were famous before inclusion in an index (such as
> netflix for SP500 and any stock in Dow 30). But including such
> informational channels involve careful examination of multitude of data
> sources and ruling out the alternates one by one. It also involves
> understanding the various forces at play (or institutional knowledge).
>
> Regards
>
> Nitish
>
> p.s.: I think it is borderline not appropriate discussion for this list,
> but since it asked for an R code it deserves some consideration.
>
>
> On Wed, May 9, 2012 at 9:04 AM, Richard Herron
> <richard.c.herron at gmail.com>wrote:
>
>> Is this an R question?
>>
>> Are you taking about anomalies that disappear after we discover them? If we
>> discover an anomaly and it disappears, then we have to wonder if we priced
>> it right before or after. See the size effect.
>>
>> http://schwert.ssb.rochester.edu/hbfech15.pdf
>>
>> Richard Herron
>>
>>
>> On Wed, May 9, 2012 at 8:01 AM, Wei-han Liu <weihanliu2002 at yahoo.com>
>> wrote:
>>
>> > Hi R users:
>> >
>> > There are some possible candidates of self-fulfilling prophecies in
>> > financial study.
>> >
>> > Could some people share some thoughts about the relevant theories,
>> > econometric tests, and R packages for implementation?
>> >
>> > Thanks for your attention and sharing.
>> >
>> > Wei-han
>> >        [[alternative HTML version deleted]]
>> >
>> >
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>
>
>
> --
> Have fun.
>
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