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Investor bias, risk and price volatility

Ali Yavuz Polat (Department of Economics, Abdullah Gul University, Kayseri, Turkey)

Journal of Economic Studies

ISSN: 0144-3585

Article publication date: 29 November 2022

22

Abstract

Purpose

This study proposes a framework based on salience theory and shows that focusing on one type of risk (idiosyncratic or systemic) can explain overpricing of securities ex ante, and resales at low prices during crisis periods.

Design/methodology/approach

The author consider an overlapping generations (OLG) model where each generation lives for two periods and there is no population growth. Agents (investors) start their lives with an endowment W > 0 and have mean-variance utility. They invest their endowment when young and consume when old. Each period, the young investors optimally choose their portfolio from different risky assets acquired from the old generation, all assumed to be in fixed supply.

Findings

The author show that investor salience bias can explain excess volatility of asset prices and the resulting fire-sales in periods of financial turmoil. A change in salience – from one component (idiosyncratic) to the other (systemic) – will generate excess volatility. Interestingly, higher risk aversion generally exacerbates the excess volatility of prices. Moreover, the model predicts that if a big systemic shock hits the financial system, due to salience bias the price of systemic assets falls sharply. This relates to the observed fire-sales of assets during the global financial crisis.

Practical implications

The proposed model and results suggest that there may be a scope for intervention in financial markets during turbulences. In terms of ex ante policies the study suggests that investors and regulator should use better risk assessment technologies.

Originality/value

This is the first study constructing a tractable model based on the argument that investor salience may exacerbate the excess volatility of prices during financial downturns. The author relate salience to two types of risk; idiosyncratic and systemic and assume that investors' risk perception is biased towards the type of risk that is currently salient based on prior beliefs or past data. The author show that the diversification fallacy of the precrisis period, where seemingly safe assets were overpriced, can be explained by agents overweighing idiosyncratic risk and ignoring systemic risk.

Keywords

Acknowledgements

The author conveys his special thanks to Fabrizio Adriani. The author also benefited from comments be S. Bougheas, A. Boukouras, T. Movahedi, J. Arshad and M. İsmaili.

Citation

Polat, A.Y. (2022), "Investor bias, risk and price volatility", Journal of Economic Studies, Vol. ahead-of-print No. ahead-of-print. https://doi.org/10.1108/JES-04-2022-0211

Publisher

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Emerald Publishing Limited

Copyright © 2022, Emerald Publishing Limited

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