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Can the Market Multiply and Divide? Non‐Proportional Thinking in Financial Markets
Author(s) -
SHUE KELLY,
TOWNSEND RICHARD R.
Publication year - 2021
Publication title -
the journal of finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 18.151
H-Index - 299
eISSN - 1540-6261
pISSN - 0022-1082
DOI - 10.1111/jofi.13059
Subject(s) - volatility (finance) , economics , stock (firearms) , market liquidity , financial economics , capital asset pricing model , liberian dollar , leverage effect , monetary economics , leverage (statistics) , stock market , econometrics , finance , autoregressive conditional heteroskedasticity , mechanical engineering , machine learning , computer science , engineering , paleontology , horse , biology
We hypothesize that investors partially think about stock price changes in dollar rather than percentage units, leading to more extreme return responses to news for lower‐priced stocks. Consistent with such non‐proportional thinking, we find a doubling in price is associated with a 20% to 30% decline in volatility and beta (controlling for size/liquidity). To identify a causal price effect, we show that volatility jumps following stock splits and drops following reverse splits. Lower‐priced stocks also respond more strongly to firm‐specific news. Non‐proportional thinking helps explain asset pricing patterns such as the size‐volatility/beta relation, the leverage effect puzzle, and return drift and reversals.