1

Lecture 2:

NON-STANDARD DECISION MAKING:

ATTENTION
Behavioral Finance (FIN 550E)
Xing Huang
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Behavioral Finance:
The topics
Prototypical economist conception of human behavior (Rabin, 2002):

Non-standard preference:
Non-standard decision making:
Non-standard beliefs: • Reference dependence:
• Limited attention: opportunity set • with as reference point
(neglect less salient alternatives) • Overconfidence: • Present-bias preference: time
• Menu effects inconsistency
• wrong or
• Framing • Social preference: where is allocation
• Law of small numbers:
• Persuasion of others
• wrong forecast of
• Mental accounting
• Over-inference:
• Emotions and sensations
• excessive updating of
• Happiness

Integrate these findings into the market ➝

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Le ct u re O ut l i ne

• Limited attention: underreaction

• introduction and conceptual framework
• Empirical evidence
• Salience, competing stimuli
• Opaqueness

• Attention grabbing: overreaction

• Empirical evidence
• Empirical measure of investor’s attention
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att en ti o n
Introduction

• Attention is limited resource

• Psychology experiments: dichotic listening (Broadbent, 1958)

• Hear two messages: * in left ear, ** in right ear
• Instructed to attend to message in one ear
• Asked about message in other ear  can not remember it
• Asked to rehearse a number (or a note) in their head  remember much less

• How do agents optimize given limited resources?

• In a world with a plethora of stimuli, which ones do agents attend to?

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L i mi t e d at te n ti on
Conceptual framework

• Consider a firm’s fundamental value contains two components:

• visible component
• opaque component

• What does inattention mean?

• Investors perceive the value
• What does capture? what does mean? what happens to attention when increases?

• What affects the degree of inattention ?

• Salience of the opaque component or the number of competing stimuli
• The opaqueness of the component
• The inattentive/attentive fraction of investors
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E ar ni n gs an n oun c em en t

• Historically, investors have focused on a single number, “Earnings per share,” calculated as Net
Income / Number of shares outstanding.

• What is the information contained in the announcement?

• Earnings surprises measured using various methods

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Pos t -e arn i n gs
An nou n ce me n t Dr i ft (PE AD )
• Under efficient market hypothesis, what is the prediction?

• Cumulative abnormal return (CAR) for portfolios sorted on

surprise

• Multiple ways to measure AR and CAR:

• Adjusted by market return
• Adjusted by portfolios with similar firm
characteristics (market cap, B/M, past returns)
• Adjusted by asset pricing models (e.g., CAPM)
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Pos t -e arn i n gs
An nou n ce me n t Dr i ft (PE AD )
• Pre-event run-up

• Consistent or inconsistent with (semi-strong) EMH?

• Event-day reaction

• Consistent/inconsistent with (semi-strong) EMH?

• Post-event drift

• Consistent/inconsistent with (semi-strong) EMH?

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Friday Earnings Announcement

Hypothesis

Investors are more likely to be inattended to earnings announcement on Friday than on other weekdays.

Inattention leads to delayed absorption of information.

Initial response vs. delayed response

Delayed
Delayed

Initial
Initial

Source: Dellavigna, S. and J. Pollet, 2009, Investor Inattention and Friday Earnings Announcements. Journal of
Finance 64, 709–749.
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Friday Earnings Announcement

Source: Dellavigna, S. and J. Pollet, 2009, Investor Inattention and Friday Earnings Announcements. Journal of
Finance 64, 709–749.
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Friday Earnings Announcement

Linear relationship with quantile groups

But non-linear relationship with earnings surprises

Source: Dellavigna, S. and J. Pollet, 2009, Investor Inattention and Friday Earnings Announcements. Journal of
Finance 64, 709–749.
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Friday Earnings Announcement

Source: Dellavigna, S. and J. Pollet, 2009, Investor Inattention and Friday Earnings Announcements. Journal of
Finance 64, 709–749.
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Driven to Distraction

What other scenarios investors are distracted?

E.g. competing news events (other public disclosures)

Use the number of earnings announcements to measure distraction

Predictions:

• Initial response: high news days ___ low news days

• Delayed response: high news days ___ low news days

Source: Hirshleifer, D., L. Sonya, and S. Teoh, 2009, Driven to Distraction: Extraneous Events and Underreaction to
Earnings News, Journal of Finance 64, 2289-2325.
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Driven to Distraction

Source: Hirshleifer, D., L. Sonya, and S. Teoh, 2009, Driven to Distraction: Extraneous Events and Underreaction to
Earnings News, Journal of Finance 64, 2289-2325.
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Driven to Distraction

Source: Hirshleifer, D., L. Sonya, and S. Teoh, 2009, Driven to Distraction: Extraneous Events and Underreaction to
Earnings News, Journal of Finance 64, 2289-2325.
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Being Surprised by the

Unsurprising
Motivation

• Many companies have predictable seasonal patterns in earnings

• Lots of studies correct for seasonality, but not much focus on whether seasonality itself is
correctly priced

• BUT apparent simplicity is easy to overstate

• Identifying seasonal quarters is fairly easy, but making precise corrections may not be

Source: Chang, T. Y., Hartzmark, S. M., Solomon, D. H., & Soltes, E. F. (2017). Being surprised by the unsurprising:
Earnings seasonality and stock returns. The Review of Financial Studies, 30(1), 281-323.
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Being Surprised by the

Unsurprising
An Illustrative Example
Rank Year Qtr EPS Rank Year Qtr EPS Rank Year Qtr EPS
• What does a seasonal firm look like? 63 2005 4 1.8 42 2005 2 0.02 21 1996 1 -0.08
62 2004 4 1.65 41 1997 1 0.01 20 1995 3 -0.15
61 1996 4 1.63 40 1997 2 0.01 19 2008 2 -0.19
• An example: Borders Books (BGP) 60 2003 4 1.56 39 1997 3 0.01 18 2005 3 -0.2
59 2001 4 1.35 38 2000 1 0.01 17 2001 1 -0.24
58 2002 4 1.34 37 2003 3 0.01 16 2006 1 -0.31
• 63 quarterly earnings numbers
57 1999 4 1.27 36 2000 2 0 15 1995 4 -0.32
56 2007 4 1.14 35 2001 2 0 14 2007 2 -0.34
55 1998 4 1.13 34 1998 3 -0.01 13 2007 1 -0.48
Quarter Avg. Earnings Earnings 54 1997 4 1.05 33 2004 3 -0.01 12 2008 1 -0.5
per Share Announcement 53 2000 4 0.96 32 1999 3 -0.02 11 2006 3 -0.56
Return
(Mkt-adjusted) 52 2009 4 0.96 31 2002 3 -0.02 10 2009 3 -0.63
51 2006 4 0.76 30 1999 2 -0.03 9 2007 3 -0.67
1 -0.2773 50 2008 4 0.48 29 2000 3 -0.03 8 2010 2 -0.74
2 -0.3863 49 2004 2 0.1 28 2001 3 -0.04 7 2009 2 -0.75
48 2003 2 0.06 27 1996 2 -0.05 6 2010 3 -1.03
3 -0.3913
47 1998 1 0.05 26 1999 1 -0.05 5 2010 1 -1.08
4 0.9525 46 2002 1 0.05 25 1996 3 -0.06 4 2009 1 -1.44
45 2002 2 0.04 24 2003 1 -0.06 3 2010 4 -1.52
44 1998 2 0.03 23 2006 2 -0.06 2 2008 3 -2.85
43 2004 1 0.03 22 2005 1 -0.07 1 1995 2 -4.28
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Being Surprised by the

Unsurprising
Year Qtr EPS Measuring seasonality
1995 4 -0.32
1996 1 -0.08
1996 2 -0.05 • Trying to capture the idea that earnings are reliably
1996 3 -0.06 bigger in one quarter than others
1996 4 1.63
1997 1 0.01 • Start in the current quarter, take the previous 5
1997 2 0.01
years of quarterly earnings per share, adjusted for
1997 3 0.01
1997 4 1.05 splits
1998 1 0.05
1998 2 0.03 • Example: Borders in Q3 2000
1998 3 -0.01
1998 4 1.13
1999 1 -0.05
1999 2 -0.03
1999 3 -0.02
1999 4 1.27
2000 1 0.01
2000 2 0
2000 3 -0.03 Source: Chang, T. Y., Hartzmark, S. M., Solomon, D. H., & Soltes, E. F. (2017). Being surprised by the unsurprising:
Earnings seasonality and stock returns. The Review of Financial Studies, 30(1), 281-323.
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Being Surprised by the

Year Qtr EPS Rank Unsurprising
1995 4 -0.32 1
1996 1 -0.08 2 Measuring seasonality
1996 3 -0.06 3
1996 2 -0.05 4
• Rank the 20 earnings announcements from lowest to highest earnings
1999 1 -0.05 5
per share
1999 2 -0.03 6
2000 3 -0.03 7
1999 3 -0.02 8 • For the current quarter (Q3 2000), compute the average rank of the
1998 3 -0.01 9 past five announcements from the same quarter of the year
2000 2 0 10
1997 1 0.01 11 • Average Rank of Q3 2000 = ?
1997 2 0.01 12
1997 3 0.01 13
2000 1 0.01 14
1998 2 0.03 15
1998 1 0.05 16
1997 4 1.05 17
1998 4 1.13 18
1999 4 1.27 19
1996 4 1.63 20 Source: Chang, T. Y., Hartzmark, S. M., Solomon, D. H., & Soltes, E. F. (2017). Being surprised by the unsurprising:
Earnings seasonality and stock returns. The Review of Financial Studies, 30(1), 281-323.
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Being Surprised by the

Year Qtr EPS Rank Unsurprising
1995 4 -0.32 1
1996 1 -0.08 2 Measuring seasonality
1996 3 -0.06 3
1996 2 -0.05 4 • Q3 2000 earnings were announced in November 2000
1999 1 -0.05 5
1999 2 -0.03 6 • In November 2000, Borders rank of 8 was in the 11.8th percentile
2000 3 -0.03 7 among all firms announcing in that month
1999 3 -0.02 8 2000 Q3 2000 Q4 2001 Q1
1998 3 -0.01 9
2000 2 0 10 Top 20% Top 20% Top 20%
1997 1 0.01 11
1997 2 0.01 12
1997 3 0.01 13
2000 1 0.01 14
1998 2 0.03 15
1998 1 0.05 16
Borders Btm 20% Btm 20% Btm 20%
1997 4 1.05 17 Books
1998 4 1.13 18
1999 4 1.27 19
1996 4 1.63 20 Source: Chang, T. Y., Hartzmark, S. M., Solomon, D. H., & Soltes, E. F. (2017). Being surprised by the unsurprising:
Earnings seasonality and stock returns. The Review of Financial Studies, 30(1), 281-323.
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Being Surprised by the

Unsurprising
Seasonality and Abnormal Returns
Table II - Earnings Seasonality and Abnormal Returns
Panel A - Base Four Factor Regressions
Earnings (VW) (EW)
Rank Intercept Intercept MKTRF SMB HML UMD R2 N
1 (Low) 0.358 *** 0.306 *** 0.948 *** 0.566 *** 0.370 *** -0.039 * 0.868 492
(2.77) (3.35) (45.68) (19.27) (11.71) (-1.95)

2 0.159 0.278 *** 1.004 *** 0.701 *** 0.281 *** -0.025 0.908 492
(1.24) (3.37) (53.52) (26.36) (9.83) (-1.39)

3 0.452 *** 0.291 *** 1.001 *** 0.686 *** 0.178 *** -0.041 ** 0.904 492
(2.82) (3.43) (51.86) (25.07) (6.05) (-2.19)

4 0.216 * 0.375 *** 0.986 *** 0.653 *** 0.179 *** 0.031 * 0.912 492
(1.69) (4.77) (55.24) (25.81) (6.59) (1.82)

5 (High) 0.909 *** 0.653 *** 0.936 *** 0.473 *** 0.292 *** -0.049 ** 0.854 492
(6.03) (6.98) (44.02) (15.69) (9.03) (-2.41)

5-1 0.551 *** 0.347 *** -0.011 -0.093 *** -0.077 ** -0.010 0.020 492
(3.14) (3.13) (-0.45) (-2.61) (-2.02) (-0.42)
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Review: size, value, momentum

factors

• The CAPM fails to explain some empirical facts:

• Small cap predicts high future returns
• Higher book-to-market ratio (B/M) ratio predicts high future returns
• Momentum: Positive short-term autocorrelation (one-year)
• Long-term reversal: Negative long-term autocorrelation (3 to 5 years)

• Multi-factor models:
• is excess return on the market
• SMB: Small Minus Big
• HML: High B/M Minus Low B/M = value minus growth
• UMD (MOM): Up Minus Down = winner minus loser
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Thinking Outside the Borders

Construct foreign information proxy
Response

• Investors are inattended to or lack understanding of foreign information

• Stock market underreacts to foreign information
• Mispricing in multinational firms  Predictable patterns

Source: X. Huang, “Thinking Outside the Borders: Investors’ Underreaction to Foreign Operations”, 2015, Review of
Financial Studies 28, 3109-3152.
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Thinking Outside the Borders

Construct foreign information proxy

Source: X. Huang, “Thinking Outside the Borders: Investors’ Underreaction to Foreign Operations”, 2015, Review of
Financial Studies 28, 3109-3152.
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Thinking Outside the Borders

Portfolio formation

07/01/2001 08/01/2001 06/01/2002

Sort on:

High High High

ForInfo ForInfo ForInfo

Low Low Low

ForInfo ForInfo ForInfo

Source: X. Huang, “Thinking Outside the Borders: Investors’ Underreaction to Foreign Operations”, 2015, Review of
Financial Studies 28, 3109-3152.
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Thinking Outside the Borders

Tr a d i n g s t r a t e g y r e t u r n s
The trading strategy could
generate abnormal return of
~10% per year.

Source: X. Huang, “Thinking Outside the Borders: Investors’ Underreaction to Foreign Operations”, 2015, Review of
Financial Studies 28, 3109-3152.
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C u s t o m e r- S u p p l i e r L i n k s
Hypothesis

Source: L. Cohen and A. Frazzini. "Economic Links and Predictable Returns.“, 2008, Journal of Finance 63, 1977-
2011.
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C u s t o m e r- S u p p l i e r L i n k s
Portfolio formation and returns

• At the beginning of every calendar month, sort stocks on the return of its principal customers of
the previous month.
• Long the top quintile, and short the bottom quintile.

The trading strategy could

generate abnormal return of
15~18% per year.

Source: L. Cohen and A. Frazzini. "Economic Links and Predictable Returns.“, 2008, Journal of Finance 63, 1977-
2011.
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Lazy Prices
Hypothesis

• When firms make an active change in their 10K or 10Q, this may convey important signals about
future firm operations

• If investors can not interpret the changes in language, we expect underreaction in stock prices.

• Prices respond when the information is later revealed through news, events, or earnings

Source:, Cohen, L., Malloy, C., & Nguyen, Q. (2020). Lazy prices. The Journal of Finance, 75(3), 1371-1415.
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Lazy Prices
Example
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Lazy Prices
Example
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Lazy Prices
Measure active changes

How to measure active changes in text?

• : We expect demand to increase.
• : We expect worldwide demand to increase.
• : We expect weakness in sales.
# words in
# words in union
intersection

Source:, Cohen, L., Malloy, C., & Nguyen, Q. (2020). Lazy prices. The Journal of Finance, 75(3), 1371-1415.
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Lazy Prices
Portfolio returns

Source:, Cohen, L., Malloy, C., & Nguyen, Q. (2020). Lazy prices. The Journal of Finance, 75(3), 1371-1415.