investors stay out of the market and there is less information revelation.
This increase in volatility after a downturn is the source of the skewness.
One prediction of this idea is that stocks which investors disagree about
more should exhibit greater skewness. Chen, Hong, and Stein (2001) test
this idea using increases in turnover as a sign of investor disagreement.
They show that stocks whose turnover increases subsequently display greater
skewness.
5.3. PreferencesEarlier, we discussed Barberis, Huang, and Santos (2001), which tries to ex-
plain aggregatestock market behavior by combining loss aversion and nar-
row framing with an assumption about how the degree of loss aversion
changes over time. Barberis and Huang (2001) show that applying the
same ideas to individual stocks can generate the evidence on long-term re-
versals and on scaled-price ratios. The key idea is that when investors hold
a number of different stocks, narrow framing may induce them to derive
utility from gains and losses in the value of individualstocks. The specifica-
tion of this additional source of utility is exactly the same as in BHS, except
that it is now applied at the individual stock level instead of at the portfolio
level: the investor is loss averse over individual stock fluctuations and the
pain of a loss on a specific stock depends on that stock’s past performance.
To see how this model generates a value premium, consider a stock
which has had poor returns several periods in a row. Precisely because the
investor focuses on individual stock gains and losses, he finds this painful
and becomes especially sensitive to the possibility of further losses on the
stock. In effect, he perceives the stock as riskier, and discounts its future
cash flows at a higher rate: this lowers its price/earnings ratio and leads to
higher subsequent returns, generating a value premium. In one sense, this
model is narrower than those in the “beliefs” section, section 5.1, as it does
not claim to address momentum. In another sense, it is broader, in that it
simultaneously explains the equity premium and derives the risk-free rate
endogenously.
The models we describe in sections 5.1, 5.2, and 5.3 focus primarily on mo-
mentum, long-term reversals, the predictive power of scaled-price ratios
and post-earnings announcement drift. What about the other examples of
anomalous evidence with which we began section 5? In section 7, we argue
that the long-run return patterns following equity issuance and repurchases
may be the result of rational managers responding to the kinds of noise
traders analyzed in the preceding behavioral models. In short, if investors
cause prices to swing away from fundamental value, managers may try to
time these cycles, issuing equity when it is overpriced, and repurchasing it
when it is cheap. In such a world, equity issues will indeed be followed by
46 BARBERIS AND THALER