Can the Market Multiply and Divide? Non-Proportional Thinking in Financial Markets

Kelly Shue and Richard R. Townsend

No 25751, NBER Working Papers from National Bureau of Economic Research, Inc

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.

JEL-codes: D03 D9 D91 G02 G12 G14 G4 G41 (search for similar items in EconPapers)
Date: 2019-04
New Economics Papers: this item is included in nep-fmk
Note: AP
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Citations: View citations in EconPapers (1)

Published as KELLY SHUE & RICHARD R. TOWNSEND, 2021. "Can the Market Multiply and Divide? Non‐Proportional Thinking in Financial Markets," The Journal of Finance, vol 76(5), pages 2307-2357.

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