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September 27, 2019 Friday 08:04:11 AM IST

Stock Market Investing is Not as Price Sensitive As Imagined

Photo by Gerd Altmann for Pixabay.com

Researchers at Caltech (California Institute of Technology) have tested the subjective expected utility (SEU) theory that explains how people make risky investments in stocks. It has revealed that investors are not price sensitive as postulated in the SEU theory. 
Due to difficulty in validating data in real life as fundamental economic conditions cannot be controlled, the researcersh Federico Echenique and Kota Saito did controlled laboratory experiments with college students and, more recently, in online experiments in a study funded by the TIAA Institute, the research arm of the financial planning company. In those experiments, subjects chose how much to invest in a set of assets from which they would earn monetary rewards based on the performance of the assets. Participants were given a choice between purchasing two stocks, for which the unit prices varied, while the fundamental economic conditions underlying stock performance were kept fixed. SEU would predict that investment in an expensive stock must be reflected in optimistic beliefs. While beliefs are unobservable, by presenting subjects with multiple investment opportunities with fixed underlying fundamentals, SEU presumes there are limits to how often investors will buy the more expensive stock. Both the laboratory and online experiments, however, generated surprising results showing that most people were not as price sensitive as the SEU theory would have predicted. 
The data also revealed that those who had ranked higher in previous cognitive and financial literacy tests acted significantly more consistently with SEU. In contrast, a person's age was found to have no effect on the outcome of the tests. "Age is not predictive of compliance with the theory," says Echenique. "This is of particular interest toTIAA and retirement planners who want to assess how individuals of a different age respond to financial decisions."

"Our data showed that people's decisions were not entirely consistent with the theory," says Saito. "While the model did accurately predict the general direction in which people would react to prices and quantities, generally buying less assets as they become more expensive, their buying behavior did not change to the extent the SEU theory would predict." The researchers said they were also surprised to see no differences between the students they tested in a lab and the adults who answered survey questions via a computer program. 
What are the next steps? The economists are thinking about how they might revise SEU theories to be more accurate. 
"One way to adjust the model would be to make it less precise, and only require interplay between prices and quantities," says Echenique. "In this way, we would be putting less emphasis on the idea that people have probabilities in mind for various stocks."

Source: Caltech