Showing papers by "Andrei Shleifer published in 1990"

Noise Trader Risk in Financial Markets

Abstract: We present a simple overlapping generations model of an asset market in which irrational noise traders with erroneous stochastic beliefs both affect prices and earn higher expected returns. The unpredictability of noise traders' beliefs creates a risk in the price of the asset that deters rational arbitrageurs from aggressively betting against them. As a result, prices can diverge significantly from fundamental values even in the absence of fundamental risk. Moreover, bearing a disproportionate amount of risk that they themselves create enables noise traders to earn a higher expected return than rational investors do. The model sheds light on a number of financial anomalies, including the excess volatility of asset prices, the mean reversion of stock returns, the underpricing of closed-end mutual funds, and the Mehra-Prescott equity premium puzzle.

Positive Feedback Investment Strategies and Destabilizing Rational Speculation

Abstract: Analyses of the role of rational speculators in financial markets usually presume that such investors dampen price fluctuations by trading against liquidity or noise traders This conclusion does not necessarily hold when noise traders follow positive-feedback investment strategies buy when prices rise and sell when prices fall In such cases, it may pay rational speculators to try to jump on the bandwagon early and to purchase ahead of noise trader demand If rational speculators' attempts to jump on the bandwagon early trigger positive-feedback investment strategies, then an increase in the number of forward-looking rational speculators can lead to increased volatility of prices about fundamentals

The Allocation of Talent: Implications for Growth

Abstract: A country's most talented people typically organize production by others, so they can spread their ability advantage over a larger scale. When they start firms, they innovate and foster growth, but when they become rent seekers, they only redistribute wealth and reduce growth. Occupational choice depends on returns to ability and to scale in each sector, on market size, and on compensation contracts. In most countries, rent seeking rewards talent more than entrepreneurship does, leading to stagnation. Our evidence shows that countries with a higher proportion of engineering college majors grow faster; whereas countries with a higher proportion of law concentrators grow slower.

Positive Feedback Investment Strategies and Destabilizing Rational Speculation

Abstract: Analyses of rational speculation usually presume that it dampens fluctuations caused by "noise" traders. This is not necessarily the case if noise traders follow positivefeedback strategies-buy when prices rise and sell when prices fall. It may pay to jump on the bandwagon and purchase ahead of noise demand. If rational speculators' early buying triggers positive-feedback trading, then an increase in the number of forwardlooking speculators can increase volatility about fundamentals. This model is consistent with a number of empirical observations about the correlation of asset returns, the overreaction of prices to news, price bubbles, and expectations. WHAT EFFECT DO RATIONAL speculators have on asset prices? The standard answer, dating back at least to Friedman (1953), is that rational speculators must stabilize asset prices. Speculators who destabilize asset prices do so by, on average, buying when prices are high and selling when prices are low; such destabilizing speculators are quickly eliminated from the market. By contrast, speculators who earn positive profits do so by trading against the less rational investors who move prices away from fundamentals. Such speculators rationally counter the deviations of prices from fundamentals and so stabilize them. Recent work on noise trading and market efficiency has accepted this argument (Figlewski, 1979; Kyle, 1985; Campbell and Kyle, 1988; DeLong, Shleifer, Summers, and Waldmann, 1987). In this work, risk aversion keeps rational speculators from taking large arbitrage positions, so noise traders can affect prices. Nonetheless, the effect of rational speculators' trades is to move prices in the direction of, even if not all the way to, fundamentals. Rational speculators buck noisedriven price movements and so dampen, but do not eliminate, them. In this paper we present a possibly empirically important exception to this argument, based on the prevalence of positive feedback investors in financial markets. Positive feedback investors are those who buy securities when prices rise and sell when prices fall. Many forms of behavior common in financial markets can be described as positive feedback trading. It can result from extrapolative expectations about prices, or trend chasing. It can also result from stoploss orders, which effectively prompt selling in response to price declines. A

Do Managerial Objectives Drive Bad Acquisitions

Abstract: In a sample of 326 US acquisitions between 1975 and 1987, three types of acquisitions have systematically lower and predominantly negative announcement period returns to bidding firms. The returns to bidding shareholders are lower when their firm diversifies, when it buys a rapidly growing target, and when its managers performed poorly before the acquisition. These results suggest that managerial objectives may drive acquisitions that reduce bidding firms' values. THERE IS NOW CONSIDERABLE evidence that making acquisitions is a mixed blessing for shareholders of acquiring companies. Average returns to bidding shareholders from making acquisitions are at best slightly positive, and significantly negative in some studies (Bradley, Desai and Kim 1988, Roll 1986). Some have suggested that negative bidder returns are purely a consequence of stock financing of acquisitions that leads to a release of adverse information about acquiring firms (Asquith, Bruner, and Mullins 1987). In this case, negative bidder returns are not evidence of a bad investment. An alternative interpretation of poor bidder performance is that bidding firms overpay for the targets they acquire. In this paper, we present evidence that some types of bidders systematically overpay. There are at least two reasons why bidding firms' managers might overpay in acquisitions, thereby truly reducing the wealth of their shareholders as opposed to just revealing bad news about their firm. According to Roll (1986), managers of bidding firms are infected by hubris, and so overpay for targets because they overestimate their own ability to run them. Another view of overpayment is that managers of bidding firms pursue personal objectives other than maximization of shareholder value. To the extent that acquisitions serve these objectives, managers of bidding firms are willing to pay more for targets than they are worth to bidding firms' shareholders. Our view is that when a firm makes an acquisition or any other investment, its manager considers both his personal benefits from the investment and the consequences for the market value of the firm. Some investments are particularly attractive from the former perspective: they contribute to long term growth of the firm, enable the manager to diversify the risk on his human capital, or

The Noise Trader Approach to Finance

Abstract: This paper reviews an alternative to the efficient markets approach that we and others have recently pursued. Our approach rests on two assumptions. First, some investors are not fully rational and their demand for risky assets is affected by their beliefs or sentiments that are not fully justified by fundamental news. Second, arbitrage - defined as trading by fully rational investors not subject to such sentiment - is risky and therefore limited. The two assumption together imply that changes in investors sentiment are not fully countered by arbitrageurs and so affect security returns. We argue that this approach to financial markets is in many ways superior to the efficient markets paradigm. Our case for the noise trader approach is threefold. First, theoretical models with limited arbitrage are both tractable and more plausible than models with perfect arbitrage. The efficient markets hypithesis obtains only as an extreme case of perfect riskless arbitrage that unlikely to apply in practice. Second, the investors sentiment/ limited arbitrage approach yields a more accurate description of financial markets than the efficient markets paradigm. The approach not only explains the available anomalies, but also readly explains board features of financial markets such as trading volume and actual investment strategies. Third, and most importantly, this approach yields new and testable implications about asset prices, some of which have been proved to be consistent with the data. It is absolutely not true that introducing a degree of irrationality of some investors into models of financial markets "eliminates all discipline and can explain anything".

The Stock Market Investments: Is the Market a Sideshow?

Abstract: RECENT EVENTS and research findings increasingly suggest that the stock market is not driven solely by news about fundamentals. There seem to be good theoretical as well as empirical reasons to believe that investor sentiment, also referred to as fads and fashions, affects stock prices. By investor sentiment we mean beliefs held by some investors that cannot be rationally justified. Such investors are sometimes referred to as noise traders. To affect prices, these less-than-rational beliefs have to be correlated across noise traders, otherwise trades based on mistaken judgments would cancel out. When investor sentiment affects the demand of enough investors, security prices diverge from fundamental values. The debates over market efficiency, exciting as they are, would not be important if the stock market did not affect real economic activity. If the stock market were a sideshow, market inefficiencies would merely redistribute wealth between smart investors and noise traders. But if the stock market influences real economic activity, then the investor sentiment that affects stock prices could also indirectly affect real activity.

Hostile Takeovers in the 1980s: The Return to Corporate Specialization

Abstract: HOSTILE TAKEOVERS invite strong reactions, both positive and negative, from academics as well as the general public. Yet fairly little is known about what drives these takeovers, which characteristically involve significant wealth gains to target firms' shareholders. The question is where these wealth gains come from. We examine the sample of all 62 hostile takeover contests between 1984 and 1986 that involved a purchase price of $50 million or more. In these contests, 50 targets were acquired and 12 remained independent. We use a sample of hostile takeovers exclusively to avoid using evidence from friendly acquisitions to judge hostile ones, as many studies have done. We examine such post-takeover operational changes as divestitures, layoffs, tax savings, and investment cuts to understand how the bidding firm could justify paying the takeover premium. We also examine the possibility of wealth losses by bidding firms' stockholders as the explanation for target shareholder gains. The analysis of post-takeover changes is complicated because once the target and the bidding firms are merged, it becomes impossible to attribute to the target the changes recorded in joint accounting data. As a consequence, we do not use such data, but rather focus on discussion in annual reports, 1OK forms, newspapers, magazines, Moody's and

The Allocation of Talent: Implications for Growth

Abstract: A country's most talented people typically organize production by others, so they can spread their ability advantage over a larger scale When they start firms, they innovate and foster growth, but when they become rent seekers, they only redistribute wealth and reduce growth Occupational choice depends on returns to ability and to scale in each sector, on market size, and on compensation contracts In most countries, rent seeking rewards talent more than entrepreneurship does, leading to stagnation Our evidence shows that countries with a higher proportion of engineering college majors grow faster; whereas countries with a higher proportion of law concentrators grow slower

Investor Sentiment and the Closed-End Fund Puzzle

Abstract: This paper examines the proposition that fluctuations in discounts on closed end funds are driven by changes in individual investor sentiment toward closed end funds and other securities. The theory implies that discounts on various funds must move together, that new funds get started when seasoned funds sell at a premium or a small discount, and that discounts on the funds fluctuate together with prices of securities affected by the same investor sentiment. The evidence supports these predictions. In particular, we find that discounts on closed end funds narrow when small stocks do well, as would be expected if closed end funds were subject to the same sentiment as small stocks, whim tern. also to be held by individual investors. The evidence thus suggests that investor sentiment affects security returns.

Do Managerial Objectives Drive Bad Acquisitions

Abstract: This paper documents for a sample of 327 US acquisitions between 1975 and 1987 three forces that systematically reduce the announcement day return of bidding firms. The returns to bidding shareholders are lower when their firm diversifies, when it buys a rapidly growing target , and when the performance of its managers has been poor before the acquisition. These results are consistent with the proposition that managerial rather than shareholders' objectives drive bad acquisitions.

Reversions of Excess Pension Assets after Takeovers

Abstract: This article evaluates pension asset reversions as a source of takeover gains. In our sample of 413 takeovers, pension funds were reverted by 15.1% of acquirers in the two years following hostile takeovers compared to 8.4% in the two years following friendly takeovers. Reversions following takeovers tend to occur in unit-benefit plans, where the potential for wealth transfer is the greatest. These results are consistent with the view that hostile takeovers breach implicit contracts between firms and employees. We estimate that the reversions can on average explain approximately 11% of the takeover premium in cases where they actually occur. Reversions are too small to be the sole, or even dominant, source of takeover gains.

The Takeover Wave of the 1980s

Abstract: The takeover wave of the 1980s moved large enterprises toward specialization and away from the diversification of the 1960s. The easy availability of funds made acquisitions affordable, while the hands-off antitrust policy allowed mergers between two firms in the same industry. Hostile takeovers and leveraged buyouts fostered the break up of conglomerates and the sell-off of divisions to buyers in the same industry; they helped speed the economy-wide move toward specialization. The poor performance of conglomerates indicates that this trend toward specialization is likely to make U.S. industry more competitive. Current state antitakeover laws are probably the result of intense lobbying by managers trying to entrench themselves; these laws do not promote competitiveness of U.S. industry. In contrast, the current accommodating federal antitrust stance encourages specialization.

Costs of Financial Distress, Delayed Calls of Convertible Bonds, and the Role of Investment Banks

Abstract: In a frictionless market with perfect information, a shareholder-wealth- maximizing firm should force conversion of its convertible bond issue into stock as soon as the bond comes in-the-money. Firms however appear to systematically delay forced conversion, sometimes for years, beyond this time. We show that the observed delays can be plausibly explained in terms of costs to shareholders of a failed conversion and the ensuing financial distress. Firms delay the forced conversion to avoid the self-fulfilling outcome that bondholders expect the conversion to fail, tender their bonds for cash, and the stock price falls to account for the costs of financial distress, in which case tendering for cash is in fact optimal. Unlike other explanations of delayed forced conversion, we can explain the common use of investment banks to underwrite these transactions, since the banks can eliminate the self-fulfilling bad outcome.

Costs of Financial Distress, Delayed Calls of Convertible Bonds, and the Role of Investment Banks

Abstract: In a frictionless market with perfect information, a shareholder-wealth- maximizing firm should force conversion of its convertible bond issue into stock as soon as the bond comes in-the-money. Firms however appear to systematically delay forced conversion, sometimes for years, beyond this time. We show that the observed delays can be plausibly explained in terms of costs to shareholders of a failed conversion and the ensuing financial distress. Firms delay the forced conversion to avoid the self-fulfilling outcome that bondholders expect the conversion to fail, tender their bonds for cash, and the stock price falls to account for the costs of financial distress, in which case tendering for cash is in fact optimal. Unlike other explanations of delayed forced conversion, we can explain the common use of investment banks to underwrite these transactions, since the banks can eliminate the self-fulfilling bad outcome.

The Bubble of 1929: Evidence from Closed-End Funds

Abstract: Closed-end mutual funds provide one of the few cases in which economists can observe "fundamental" values directly, and compare them to market values: the fundamental value of a closed-end fund is simply the net asset value of its portfolio. We use the difference between prices and asset values of closed-end funds at the end of the 1920s as a measure of investment sentiment. In the late l920s closed-end funds sold at large premia: at the peak, they appear willing to pay 60 percent more for closed-end funds than the post-WWII norm. Such substantial overpricing of closed-end funds -- where fundamentals are known and observed -- suggests that other assets were selling at prices above fundamentals as well. The association between movements in the medium closed-end fund discount and movements in broad stock price indices leads us to conclude that the stocks making up the S & P composite were priced at least 30 percent above fundamentals in the summer of 1929.

Noise Trader Risk in Financial Markets

Abstract: We present a simple overlapping generations model of an asset market in which irrational noise traders with erroneous stochastic beliefs both affect prices and earn higher expected returns. The unpredictability of noise traders' beliefs creates a risk in the price of the asset that deters rational arbitrageurs from aggressively betting against them. As a result, prices can diverge significantly from fundamental values even in the absence of fundamental risk. Moreover, bearing a disproportionate amount of risk that they themselves create enables noise traders to earn a higher expected return than rational investors do. The model sheds light on a number of financial anomalies, including the excess volatility of asset prices, the mean reversion of stock returns, the underpricing of closed-end mutual funds, and the Mehra-Prescott equity premium puzzle.

The Bubble of 1929: Evidence from Closed-End Funds*

Abstract: Closed-end mutual funds provide one of the few cases in which economists can observe "fundamental" values directly, and compare them to market values: the fundamental value of a closed-end fund is simply the net asset value of its portfolio. We use the difference between prices and asset values of closed-end funds at the end of the 1920s as a measure of investment sentiment. In the late l920s closed-end funds sold at large premia: at the peak, they appear willing to pay 60 percent more for closed-end funds than the post-WWII norm. Such substantial overpricing of closed-end funds -- where fundamentals are known and observed -- suggests that other assets were selling at prices above fundamentals as well. The association between movements in the medium closed-end fund discount and movements in broad stock price indices leads us to conclude that the stocks making up the S & P composite were priced at least 30 percent above fundamentals in the summer of 1929.

Externalidades como motor do crescimento

Abstract: 1. Introducao De 1986 para ca, parece que os estudos te6ricos acerca do crescimento e do desenvolvimento economicos comecaram a decolar. A atual onda de artigos foi motivada pela observacao de enormes disparidades nos niveis de renda e taxas de crescimento entre os paises. Em vez de enfocar a con­ vergencia dos padroes de vida, como se fazia com frequencia na literatura antiga, os modelos recentes objetivam gerar grandes diferencas nos resul­ tados de um pais para outro. A maneira mais importante segundo a qual este tipo de trabalho mostra grandes diferencas entre paises e atraves das externalidades. Os atores economicos que investem em capital fisico ou humano, que inovam ou que contratam ma

The Bubble of 1929: Evidence from Closed-End Funds

Abstract: Closed-end mutual funds provide one of the few cases in which economists can observe "fundamental" values directly, and compare them to market values: the fundamental value of a closed-end fund is simply the net asset value of its portfolio. We use the difference between prices and asset values of closed-end funds at the end of the 1920s as a measure of investment sentiment. In the late l920s closed-end funds sold at large premia: at the peak, they appear willing to pay 60 percent more for closed-end funds than the post-WWII norm. Such substantial overpricing of closed-end funds -- where fundamentals are known and observed -- suggests that other assets were selling at prices above fundamentals as well. The association between movements in the medium closed-end fund discount and movements in broad stock price indices leads us to conclude that the stocks making up the S & P composite were priced at least 30 percent above fundamentals in the summer of 1929.