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Can the Market Multiply and Divide? Non‐Proportional Thinking in Financial Markets

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  • KELLY SHUE
  • RICHARD R. TOWNSEND

Abstract

We hypothesize that investors partially think about stock price changes in dollar rather than percentage units, leading to more extreme return responses to news for lower‐priced stocks. Consistent with such non‐proportional thinking, we find a doubling in price is associated with a 20% to 30% decline in volatility and beta (controlling for size/liquidity). To identify a causal price effect, we show that volatility jumps following stock splits and drops following reverse splits. Lower‐priced stocks also respond more strongly to firm‐specific news. Non‐proportional thinking helps explain asset pricing patterns such as the size‐volatility/beta relation, the leverage effect puzzle, and return drift and reversals.

Suggested Citation

  • Kelly Shue & Richard R. Townsend, 2021. "Can the Market Multiply and Divide? Non‐Proportional Thinking in Financial Markets," Journal of Finance, American Finance Association, vol. 76(5), pages 2307-2357, October.
    • Handle: RePEc:bla:jfinan:v:76:y:2021:i:5:p:2307-2357
    DOI: 10.1111/jofi.13059
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