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Guy Kaplanski talks Behavioural Economics and the impact of the World Cup on Stock Market Performance

Fri, 20 Jun 2014 08:28:00 GMT

Guy KaplanskiProfessor Guy Kaplanski is the head of Financial Studies at Bar Ilan University Business School, the largest university in Israel and holds a PhD in Finance, an MBA in Finance and Marketing and a B.Sc. in Electrical and Electronic Engineering. Previously he served as a visiting professor at the University of Michigan Business School.

He has published 2 books and a wide variety of research papers in top journals mainly in the field of capital markets and behavioural finance. He has commercial experience in investment banking and consulting as well as the management of several large infrastructure projects.

Professor Kaplanski is the author of 2 papers in our feature on World Cup Economics, Sentiment, Irrationality and Market Efficiency: The Case of the 2010 FIFA World Cup and Exploitable Predictable Irrationality: The FIFA World Cup Effect on the U.S. Stock Market.

JB: How did you get interested in this area specifically?

GK: The main school of thought in economics advocates rational expectations and market efficiency. However, ever since the seminal works of Daniel Kahneman and Amos Tversky, Robert Shiler, Richard Thaler and others, the evidence accumulates in favour of the alternative school of thought asserting that, in certain situations, people behave irrationally, and mood and sentiment affect the market. What caught my attention and interested me in the argument between these two schools of thought was the large gap I noticed between the complex and sophisticated finance theories versus the unsophisticated heuristic behaviour of actual investors that asked my advice.

JB: What have been the main areas you have studied, and what are your main results?

GK: In a series of studies I show that irrational investor behaviour affects the market to a large extent which is sufficient enough to create abnormal returns. Thus, my work helps to prove that investor sentiment plays an important role in the financial markets, while pointing out and explaining several market anomalies. The most important study of mine together with Haim Levy of the Hebrew University documents a sentiment effect of aviation disasters on stock prices.

"...the effect of the FIFA World Cup sporting event is associated with a global sentiment effect, i.e. with substantial low returns in the U.S. stock market. The effect was sufficiently large enough to generate abnormal returns after transaction costs in 14 out of 15 tournaments."

We show that immediately after an aviation disaster the U.S. market decreases by more than $60 billion, whereas the estimated actual loss is no more than $1 billion. In two days a price reversal occurs. This is an important finding because it is the first time that a fully randomly occurring sentiment event effect has been identified. Previous sentiment event effects were non-random effects which occurred on the same period of the year, same day of the week, same holiday etc. Therefore they might be explained also by reasons other than sentiment. However, the aviation disaster event effect is a pure random
 

phenomenon that can be explained only by sentiment; hence, it proves the general argument that sentiment indeed affects the market. We also show for the first time that the sentiment effect is not confined to returns as the effect is also accompanied by an increase in the perceived risk: the VIX increases after aviation disasters, without an increase in actual volatility.

In three other studies we first show how the effect of the FIFA World Cup sporting event is associated with a global sentiment effect, i.e. with substantial low returns in the U.S. stock market. The effect was sufficiently large enough to generate abnormal returns after transaction costs in 14 out of 15 tournaments. In a follow up paper, we show that the discovery of the exploitable effect before the 2010 tournament, which was widely cited by practitioners, has altered the effect. While there was still a free-lunch opportunity the decline in prices reversed earlier, which illustrates how markets become more efficient over time. In the third paper with Haim Levy, Chris Veld and Yulia Veld-Merkoulova we survey actual investors in real time and show how the performance of their favourite sport teams indeed affect their market expectations. We also show that weather factors, general feeling and even the day of the week are all affecting market expectations and hence investor behaviour. These results prove that the previous found correlations between those factors and stock returns are not obtained merely by coincidence but rather driven by psychological misperceptions. In particular, tracking investors over a full year we were able to prove that the well-known medical condition seasonal affective disorder (SAD), which affects a large portion of the population, indeed affects investors’ behaviour as it distorts their expectations. This result strongly supports the seminal work of Mark Kamstra, Lisa Kramer and Maurice Levi which show that SAD is positively correlated with stock and bond prices. In two related studies we show that SAD is also correlated with the volatility risk premium and real estate prices which further strengthens the SAD argument. In another study we show that, despite common belief, at least one group of highly sophisticated investors—financial analysts—are also affected by sentiment. We show that experienced analysts are aware of sentiment, consciously incorporate it, and have control, at least to some extent, on its effect. The results present an extreme example that even professional financial analysts, let alone private investors, may find that that it is not always beneficial to bet against the trend of sentiment. It also illustrates the major role regulations can take in controlling such phenomena.

"...we predict that in the coming tournament investors, who in 2010 bought stocks relatively late, will realize that they did not enjoy the whole potential abnormal profits. Hence, they will buy stocks earlier and prices will sharply increase earlier. "

JB: How does your research in this area fit into the broader context?

GK: I hope that my work adds another stone in building the bridge between the two schools of thought mentioned above. I believe that the recent financial crisis has taught us that both schools are important and relevant for financial markets and should be integrated and reconciled in order to understand market behaviour. My work

contributes to this subject by showing empirically that indeed behavioural finance in general and investor sentiment in particular are integral parts of the market.

JB: To what extent can institutions exploit anomalies in trading behaviour over the course of the tournament? Is the same true for individual traders?

GK: In a recent study, we show that once the information on the available free lunch was available the price pattern and the sentiment effect in 2010 were changed, presumably due to the activity of sophisticated investors who exploited the sentiment effect. As a result, a substantial rally was recorded just before the games finished, despite the negative economic news during this period and despite the negative sentiment during the games period characterizing the previous World Cups. Thus, the window period to exploit the effect was much shorter than in the previous World Cups. In this paper we predict that in the coming tournament investors, who in 2010 bought stocks relatively late, will realize that they did not enjoy the whole potential abnormal profits. Hence, they will buy stocks earlier and prices will sharply increase earlier. This process will continue until eventually prices do not fall at all, and the abnormal price behaviour either completely vanishes or is small enough such that no abnormal profits can be made after transaction costs are accounted for—exactly as has occurred with other market anomalies. The expected disappearance of the World Cup anomaly by no means implies that the sentiment effect will disappear, but rather that transactions made by sophisticated investors will eventually remove the anomaly from the stock market.

JB: Which areas of research do you think would be fruitful for the future?

GK: Following the seminal work of Malcolm Baker and Jeffrey Wurgler there are still a lot of unsolved issues relating to measuring sentiment and understanding how it affects the market. A more general research field would probably be the assimilation of behavioural finance within the broader context of financial markets. Two examples for such research are the papers that reconcile the CAPM with behavioural finance, one by Haim Levy, with whom I’ve been fortunate to work with in the last decade, and the other by Constantinos Antoniou, John Doukas, and Avanidhar Subrahmanyam. Another promising related direction is the interaction between market microstructure and investor behaviour. Finally, an important and relevant subject is the identifying, understanding and eliminating of financial bubbles. In particular, it would be important to understand how the dramatic intervention of the Federal Reserve and other central banks in the bond market affects investor behaviour and spillover into the other markets including the stock and real estate markets.

Obviously, these interventions are still ongoing and the full answers to those important questions have not been written yet.

You may be interested in our article Football Special: The FIFA World Cup, Stock Market Performance and Financial Economics

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