Working Papers

Can the Market Multiply and Divide? Non-Proportional Thinking in Financial Markets 
with Richard Townsend, 
R&R Journal of Finance

First Prize AQR Insight Awards, 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.

Leverage-Induced Fire Sales and Stock Market Crashes
with Jiangze Bian, Zhiguo He, and Hao Zhou

Abstract: This paper provides direct evidence of leverage-induced fire sales leading to a major stock market crash. Our analysis uses proprietary account-level trading data for brokerage- and shadow-financed margin accounts during the Chinese stock market crash in the summer of 2015. We find that margin investors heavily sell their holdings when their account-level leverage edges toward their maximum leverage limits, controlling for stock-date and account fixed effects. Stocks that are disproportionately held by investors who are close to receiving margin calls experience high selling pressure and significant abnormal price declines that subsequently reverse over the next 40 trading days. Relative to regulated brokerage accounts, unregulated and highly-leveraged shadow-financed margin accounts contributed more to the market crash, despite the fact that these shadow accounts held a much smaller fraction of market assets.

Promotions and the Peter Principle
with Alan Benson and Danielle Li, Conditionally Accepted Quarterly Journal of Economics

Best Paper Prize, 2017 FIRCG Conference

Abstract: The best worker is not always the best candidate for manager.  In these cases, do firms promote the best potential manager or the best worker in her current job? Using microdata on the performance of sales workers at 214 firms, we find evidence consistent with the ``Peter Principle,'' which predicts that firms prioritize current job performance in promotion decisions at the expense of other observable characteristics that better predict managerial performance.  We estimate that the costs of promoting workers with lower managerial potential are high, suggesting either that firms are making inefficient promotion decisions or that  the benefits of promotion-based incentives are great enough to justify the costs of managerial mismatch.

Consistent Good News and Inconsistent Bad News
with Rick Harbaugh and John Maxwell

Abstract: Good news is more persuasive when it is more consistent, and bad news is less damaging when it is less consistent. We show when Bayesian updating supports this intuition so that a biased sender has “mean-variance news preferences” where more or less variance in the news helps the sender depending on whether the mean of the news exceeds expectations. We apply the result to selective news distortion of multiple projects by a manager interested in enhancing the perception of his skill. If news from the different projects is generally good, boosting relatively bad projects increases consistency across projects and provides a stronger signal that the manager is skilled. But if the news is generally bad, instead boosting relatively good projects reduces consistency and provides some hope that the manager is unlucky rather than incompetent. We test for evidence of such distortion by examining the consistency of reported segment earnings across different units in firms. As predicted by the model, managers appear to shift discretionary cost allocations to report more consistent earnings when overall earnings are above rather than below expectations. The mean-variance news preferences that we identify apply in a range of situations beyond our career concerns application, and differ from standard mean-variance preferences in that more variable news sometimes helps and better news sometimes hurts.

Do Managers Do Good With Other Peoples' Money?
with Ing-Haw Cheng and Harrison Hong

Summary in HLS Forum

Abstract: We show that spending on corporate social responsibility (CSR) is due partly to agency problems. Using the 2003 Dividend Tax Cut, which increased after-tax insider ownership, we find that firms with moderate levels of insider ownership cut CSR by more than firms with low levels (where the tax cut has no effect) and high levels (where agency is less of an issue). Moderate insider-ownership firms experienced larger increases in valuation. Similar insights hold in a regression-discontinuity design of close votes on shareholder-governance proposals. Individuals did not offset CSR cuts with private giving, suggesting a trade-off between governance and public goods.


A Tough Act to Follow: Contrast Effects in Financial Markets
with Samuel Hartzmark
, Forthcoming Journal of Finance

First Prize AQR Insight Awards, 2016; Finalist Hillcrest Behavioral Finance Award 2015
Summary in Alpha ArchitectAQR
Freakonomics Radio

Abstract: A contrast effect occurs when the value of a previously-observed signal inversely biases perception of the next signal. We present the first evidence that contrast effects can distort prices in sophisticated and liquid markets. Investors mistakenly perceive earnings news today as more impressive if yesterday’s earnings surprise was bad and less impressive if yesterday’s surprise was good. A unique advantage of our financial setting is that we can identify contrast effects as an error in perceptions rather than expectations. Finally, we show that our results cannot be explained by a key alternative explanation involving information transmission from previous earnings announcements. 

How Do Quasi-Random Option Grants Affect CEO Risk-Taking?
with Richard Townsend, forthcoming Journal of Finance

(Earlier version: "Swinging for the Fences: Executive Reactions to Quasi-Random Option Grants")

Abstract: We examine how an increase in stock option grants affects CEO risk-taking. The overall net effect of option grants is theoretically ambiguous for risk-averse CEOs. To overcome the endogeneity of option grants, we exploit institutional features of multi-year compensation plans, which generate two distinct types of variation in the timing of when large increases in new at-the-money options are granted. We find that, given average grant levels during our sample period, a 10 percent increase in new options granted leads to a 2.8–4.2 percent increase in equity volatility. This increase in risk is driven largely by increased leverage.

(Lead Article) Journal of Financial Economics, 2017, 123(1): 1-21.

Second place, Journal of Financial Economics Jensen Prize 2017 for best paper in t
he areas of corporate finance and organizations; Coverage: San Antonio Express News, Bloomberg, MarketWatch, PBS, CNN Money, ASU

Online Appendix

Abstract: The dramatic rise in CEO compensation during the 1990s and early 2000s is a long-standing puzzle. In this paper, we show that much of the rise can be explained by a tendency of firms to grant the same number of options each year. Number-rigidity implies that the grant-date value of option awards will grow with firm equity returns, which were very high on average during the tech boom. Further, other forms of CEO compensation did not adjust to offset the dramatic growth in the value of option pay. Number-rigidity in options can also explain the increased dispersion in pay, the difference in growth between the US and other countries, and the increased correlation between pay and firm-specific equity returns. We present evidence that number-rigidity arose from a lack of sophistication about option valuation that is akin to money illusion. We show that regulatory changes requiring transparent expensing of the grant-date value of options led to a decline in number-rigidity and helps explain why executive pay increased less with equity returns during the housing boom in the mid-2000s.

Decision-Making under the Gambler’s Fallacy: Evidence from Asylum Judges, Loan Officers, and Baseball Umpires
with Daniel Chen and Tobias Moskowitz, Quarterly Journal of Economics, 2016, 131(3): 1181-1241.

Best Paper Prize 2015 BYU Red Rock Conference, Finalist 2017 Exeter Prize
Coverage: US News, BigThink, Yahoo, Bloomberg, NPR, PBS, Washington Post, CBS
Freakonomics Radio
Online Appendix

Abstract: We find consistent evidence of negative autocorrelation in decision-making that is unrelated to the merits of the cases considered in three separate high-stakes field settings: refugee asylum court decisions, loan application reviews, and major league baseball umpire pitch calls. The evidence is most consistent with the law of small numbers and the gambler’s fallacy – people underestimating the likelihood of sequential streaks occurring by chance – leading to negatively autocorrelated decisions that result in errors. The negative autocorrelation is stronger among more moderate and less experienced decision-makers, following longer streaks of decisions in one direction, when the current and previous cases share similar characteristics or occur close in time, and when decision-makers face weaker incentives for accuracy. Other explanations for negatively autocorrelated decisions such as quotas, learning, or preferences to treat all parties fairly, are less consistent with the evidence, though we cannot completely rule out sequential contrast effects as an alternative explanation.

Screening Peers Softly: Inferring the Quality of Small Borrowers
with Rajkamal Iyer, Asim Ijaz Khwaja, and Erzo F.P. Luttmer
Management Science, 2015, 62(6): 1554-1577.

Abstract: This paper examines the performance of new online lending markets that rely on non-expert individuals to screen their peers’ creditworthiness. We find that these peer lenders predict an individual’s likelihood of defaulting on a loan with 45% greater accuracy than the borrower’s exact credit score (unobserved by the lenders). Moreover, peer lenders achieve 87% of the predictive power of an econometrician who observes all standard financial information about borrowers. Screening through soft or nonstandard information is relatively more important when evaluating lower quality borrowers. Our results highlight how aggregating over the views of peers and leveraging nonstandard information can enhance lending efficiency. 

No News is News: Do Markets Underreact to Nothing?
with Stefano Giglio
(Lead Article and Editor's Choice Article) Review of Financial Studies, 2014, 27(12): 3389-3440.

UBS Global Asset Management Award for Research in Investments, FRA 2012
Coverage: Bloomberg, RFS Blog

Abstract: As illustrated in the tale of “the dog that did not bark,” the absence of news and the passage of time often contain information. We test whether markets fully incorporate this information using the empirical context of mergers. During the year after merger announcement, the passage of time is informative about the probability that the merger will ultimately complete. We show that the variation in hazard rates of completion after announcement strongly predicts returns. This pattern is consistent with a behavioral model of underreaction to the passage of time and cannot be explained by changes in risk or frictions.

Executive Networks and Firm Policies: Evidence from the Random Assignment of MBA Peers
Review of Financial Studies
, 2013, 26(6): 1401-1442.

Wharton School-WRDS Award for the Best Empirical Finance Paper, WFA 2012
Coverage: Wall Street Journal,

Online Appendix

Abstract: Using the historical random assignment of MBA students to sections at Harvard Business School, I explore how executive peer networks can affect managerial decision-making and firm policies. Within an HBS class, firm outcomes are significantly more similar among graduates from the same section than among graduates from different sections, with the strongest effects in executive compensation and acquisitions strategy. Both compensation and acquisitions propensities have elasticities of 10-20% with respect to the mean characteristics of section peers. I demonstrate the important role of ongoing social interactions by showing that peer effects are more than twice as strong in the year immediately following staggered alumni reunions. A variety of other tests suggest that peer influence can operate through direct reactions to peer outcomes in ways that do not necessarily contribute to firm productivity.

Who Misvotes? The Effect of Differential Cognition Costs on Election Outcomes
with Erzo F.P. Luttmer
American Economic Journal: Economic Policy, 2009, 
1(1): 229-257.

Abstract: If voters have negligible cognition costs, ballot layout should not affect election outcomes. We explore deviations from rational voting using quasi-random variation in candidate name placement on ballots from the 2003 California recall election. We find that minor candidates’ vote shares almost double when their names are adjacent to the names of major candidates. All else equal, vote share gains are larger in precincts with higher percentages of poorly educated, poor, or third-party voters. A major candidate that disproportionally attracts voters from such precincts faces an electoral disadvantage. We also explore which voting technology platforms and brands mitigate misvoting.