IDEAS home Printed from https://ideas.repec.org/a/eee/ecofin/v68y2023ics1062940823001043.html
   My bibliography  Save this article

Cognitive biases, downside risk shocks, and stock expected returns

Author

Listed:
  • Li, Si
  • He, Fangyi
  • Shi, Fangquan

Abstract

This paper finds that the pricing effect of past stock downside risks in stock markets is greatly influenced by two cognitive biases: the representativeness heuristic bias and the conservatism bias. The two cognitive biases can cause investors to misreact to past downside risks of stocks, resulting in abnormal returns. Using the pseudo-Bayesian model, we theoretically describe how investors' incorrect belief updates, influenced by two cognitive biases regarding downside risks of a stock, affect future stock returns under four scenarios. Our empirical analysis confirms that biased beliefs lead to a positive correlation between short-term downside risk shocks and future stock returns, while a negative correlation exists between long-term downside risk shocks and future stock returns. This phenomenon is prevalent in the Chinese A-share market, even after controlling for several commonly used firm characteristics. Similar results are also observed in the US stock market. Furthermore, more active retail investors and low investor sentiments can strengthen the anomalous relation.

Suggested Citation

  • Li, Si & He, Fangyi & Shi, Fangquan, 2023. "Cognitive biases, downside risk shocks, and stock expected returns," The North American Journal of Economics and Finance, Elsevier, vol. 68(C).
    • Handle: RePEc:eee:ecofin:v:68:y:2023:i:c:s1062940823001043
    DOI: 10.1016/j.najef.2023.101981
    as

    Download full text from publisher

    File URL: http://www.sciencedirect.com/science/article/pii/S1062940823001043
    Download Restriction: Full text for ScienceDirect subscribers only
    File URL: https://libkey.io/10.1016/j.najef.2023.101981?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    As the access to this document is restricted, you may want to search for a different version of it.

    More about this item

    Keywords

    Representativeness Heuristic Bias; Conservatism Bias; Pseudo-Bayesian Model; Downside Risk Shock; Stock Expected Return;
    All these keywords.

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G41 - Financial Economics - - Behavioral Finance - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making in Financial Markets

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:eee:ecofin:v:68:y:2023:i:c:s1062940823001043. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    We have no bibliographic references for this item. You can help adding them by using this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Catherine Liu (email available below). General contact details of provider: http://www.elsevier.com/locate/inca/620163 .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.