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Nominal price illusion

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  • Birru, Justin
  • Wang, Baolian

Abstract

We explore the psychology of stock price levels and provide evidence that investors suffer from a nominal price illusion in which they overestimate the room to grow for low-priced stocks relative to high-priced stocks. While it has become increasingly clear that nominal price levels influence investor behavior, why prices matter to investors is a question that as of yet has gone unanswered. We find widespread evidence that investors systematically overestimate the skewness of low-priced stocks. In the broad cross-section of stocks, we find that investors substantially overweight the importance of price when forming skewness expectations. Asset pricing implications of our findings are borne out in the options market. A zero-cost option portfolio strategy that exploits investor overestimation of skewness for low-priced stocks generates significant abnormal returns. Finally, investor expectations of future skewness increase drastically on days that a stock undergoes a split to a lower nominal price. Empirically, however, future physical skewness decreases following splits.

Suggested Citation

  • Birru, Justin & Wang, Baolian, 2016. "Nominal price illusion," Journal of Financial Economics, Elsevier, vol. 119(3), pages 578-598.
  • Handle: RePEc:eee:jfinec:v:119:y:2016:i:3:p:578-598
    DOI: 10.1016/j.jfineco.2016.01.027
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    More about this item

    Keywords

    Nominal price; Skewness; Stock splits; Options; Behavioral finance;
    All these keywords.

    JEL classification:

    • G02 - Financial Economics - - General - - - Behavioral Finance: Underlying Principles
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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