Section 2- Behavioral explanations
Introduction:
Short run IPO anomaly may be the most
controversial area of IPO research. The research effort has provided numerous
analytical advances and empirical insights trying to explain the first day
price run up. Many explanations were introduced and studied, but all these
theories are unlikely to explain the persistent pattern of high initial returns
during the first trading day. It is fair to say that this anomaly is not
satisfactorily resolved and is still a puzzle.
Many researchers come to the conclusion that IPO future
researches should turn to behavioral approach and sentiment notion. Research
effort should focus more on behavioral explanations to clarify and to explain
the short run IPO behaviour, since nor the asymmetric theories neither the
explanations based on the informational symmetry are likely to give a relevant
and a reliable explanation to the underpricing anomaly, mainly after the
surprisingly and severe level of underpricing reached in 1999 and 2000, the
internet boom years. The explanations that have been advanced earlier are
unable to explain the severe percentage of underpricing observed in this
period, and turning to behavioral explanations seems to be a necessity to
resolve this short run IPO puzzle.
Ritter and Welch (2002), for example, advance clearly that
asymmetric information which has been the most convincing explanation for
decades, is not the primary driver of IPO phenomena and asymmetric information
models that have been popular among academics, have been overemphasized. Ritter
and Welch believe that future progress in the IPO literature will come from non
rational explanations.
This argument is supported by Ljungqvist (2004) who comes to
the conclusion that IPO researchers should focus on behavioral approaches to
explain why the extent of underpricing varies so much over time.
Future researches have to focus more on behavioral
explanations and turning to the behavioral approach describing the behaviour of
irrational investors and their sentiment seems to be a necessity since the
explanations and the theories that were advanced earlier are unlikely to
clarify and to explain the short run IPO puzzle, especially after the dot-com
boom. During this period, the IPO market has reached a severe level of
underpricing never seen before. So one can ask about the suitability of
«traditional» explanations and theories, and turning to behavioral
explanations seems to be the most promising area of research. Going further,
Cook, Jarrell and Kieschnicke (2003) conclude that the role of investor
sentiment is more important than previously thought.
The tendency of behavioral approach and investor sentiment is
not a new field not again discovered. The investor sentiment was introduced
earlier in the 1990's by Welch who presented the informational cascade theory.
But this approach has attracted more attention, has intrigued more and more
researchers and has taken all its impetus in this decade. Many researchers
tried to introduce this behavioral approach to explain the short run IPO
anomaly and the research effort is continuing.
In this second section, I present the Behavioral Approach in a
first paragraph by defining important notions as investor sentiment, hot IPO
market and distinguishing between individual investors and institutional
investors. Then, in a second paragraph, I summarize the most important studies
advanced asserting the presence of sentiment investors and sentiment as the
primary and main driver of underpricing phenomenon. I present the most
important findings and the main proxies used by researchers to value the
investor sentiment.
I- Definitions:
The behavioral approach asserts the presence
of «irrational» investors, also called «sentiment»
investors or «noise traders» whose investment decisions, choices,
etc, are conducted by feelings and emotions and based on sentiment which plays
a major role in their decisions.
Before going more in the details, it is reasonable to begin by
presenting some definitions of the most important notions in this section.
Clarifying some notions is important to understand the theories and the
findings of many researchers.
I-1\ The sentiment's notion:
The sentiment represents the anticipations of
the investors that are not justified by the fundamental.
The notion of sentiment characterizes the presence of
irrational investors who show undue interest in an investment opportunity, for
example for IPOs, and who are irrationally exuberant, over optimistic and over
enthusiastic about an investment. This over optimism and over enthusiasm is not
justified by fundamental. Or on the contrary, these investors are over
pessimistic and they are much dissuaded about the issues with any reason or
relevant justification. All the decisions are conducted by sentiments and
feelings.
An optimistic investor (pessimistic) expects returns that are
higher (lower) to those that could be explained by the fundamental indicators.
In other words, the sentiment can be defined by the fact that the investor is
optimistic (pessimistic) without having good (bad) economic reasons for the
being.
The sentiment felt by the investor is very complicated and
very hard to surround, since there are numerous biases that can have an impact
on the investor behaviour. The sentiment also differs from an investor to
another, it is individual and can not be foreseen. It depends on the investor's
personality, his beliefs, his thoughts...
Biases have been studied by psychologists for some time and
financial economists have recently introduced them into formal models of asset
pricing. For example, a large literature reports that people believe their
knowledge to be more accurate than it really is (Odean (1998)), and then they
overweight the information collected by themselves and underweight the
information collected by the others. In the same direction, Kaustia and Knupfer
(2008) on a sample of 57 Finnish IPOs from January 1995 through December 2000,
study the link between past personally experienced outcomes and future IPO
subscriptions. They find that personally experienced outcomes have a greater
effect on behaviour and on future IPO subscriptions, than, say just reading
about the same information without personal involvement. When deciding to
subscript in IPOs, investors overweight their personal experience more than the
information collected by the other investors, which goes in the same direction
as believing in their knowledge and in their own information.
However, there are other possible reasons for systematic
decision errors. In a recent review, Hirshleifer (2001) argues that many or
most familiar psychological biases can be viewed as outgrowths of heuristic
simplification (an imperfect decision making procedure that makes people
have reasonably good decision cheaply). We can also talk about framing
effects (wherein the description of a situation affects judgments and
choices), money illusion (wherein nominal prices affect perceptions),
and mental accounting (tracking gains and losses relative to arbitrary
reference points). We also find overconfidence (a tendency to
overestimate ones ability or judgment accuracy) which may be due to another
bias «self attribution». Experiments have shown that people
tend to attribute favourable outcomes to their abilities and unfavourable ones
and failure to chance or other external factors beyond their control (Daniel,
Hirshleifer, and Subrahmanyam (1998)). This bias is known as «self
attribution» and may even be at the origin of
«overconfidence».
This list of biases is not exhaustive and can be very long.
These psychological biases have a great effect on the
sentiment, and they also differ from an investor to another making the
sentiment a very complicated notion hard to surround or to foresee.
The IPO market presents an environment which is more prone to
investor sentiment and where irrational investors are more likely to exist,
since IPO firms by definition have no prior share price history and tend to be
young, immature, and relatively informationally opaque.
Not surprisingly, therefore, these firms are hard to value,
and it seems reasonable to assume that investors will have a wide range of
beliefs and feelings about their market values. Investors will be very
influenced by feelings and emotions in valuing the IPO and in deciding whether
to invest in.
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