Investor sentiment and short run IPO anomaly: a behavioral explanation of underpricing
par Ines Mahjoub
Institut des Hautes Etudes Commerciales - Mastère de Recherche 2010
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.
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.
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.