Stock Market Investing is Not as Price Sensitive As Imagined

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
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