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How do investors react under uncertainty?

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Author Info

  • Bird, Ron
  • Yeung, Danny

Abstract

It has long been accepted that risk plays an important role in determining valuation where risk reflects that investors are unsure of future returns but are able to express their prior expectations by a probability distribution of these returns. Knight (1921) introduced the concept of uncertainty where investors possess incomplete knowledge about this distribution and so are unable to formulate priors over all possible outcomes. One common approach for making uncertainty tractable is to assume that investors faced with uncertainty will base their decisions on the worst case scenario (i.e. follow maxmin expected utility). As a consequence it is postulated that investors will become more pessimistic as uncertainty increases, upgrading bad news and downgrading good news. Using Australian data, we find evidence that investors react to bad news at times of high market uncertainty but largely ignore good news which is consistent with them taking on a pessimistic bias. However, we also find evidence of the reverse when market uncertainty is low with investors taking on an optimistic stance by ignoring bad news but reacting to good news. We also find that the impact that market uncertainty has on the reaction of investors to new information is modified by the prevailing market sentiment at the time of the announcement. Besides throwing light on the question of how uncertainty impacts on investor behaviour, our findings seriously challenge the common assumption made that investors consistently deal with uncertainty by applying maxmin expected utility.

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Bibliographic Info

Article provided by Elsevier in its journal Pacific-Basin Finance Journal.

Volume (Year): 20 (2012)
Issue (Month): 2 ()
Pages: 310-327

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Handle: RePEc:eee:pacfin:v:20:y:2012:i:2:p:310-327

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Web page: http://www.elsevier.com/locate/pacfin

Related research

Keywords: Uncertainty; Ambiguity; Earnings announcement; Asymmetric response;

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References

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  1. Anderson, Evan W. & Ghysels, Eric & Juergens, Jennifer L., 2009. "The impact of risk and uncertainty on expected returns," Journal of Financial Economics, Elsevier, vol. 94(2), pages 233-263, November.
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  4. Matthias Gysler & Jamie Kruse & Renate Schubert, 2002. "Ambiguity and Gender Differences in Financial Decision Making: An Experimental Examination of Competence and Confidence Effects," CER-ETH Economics working paper series 02/23, CER-ETH - Center of Economic Research (CER-ETH) at ETH Zurich.
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Citations

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Cited by:
  1. Kang, Wensheng & Ratti, Ronald A., 2013. "Oil shocks, policy uncertainty and stock market return," MPRA Paper 49008, University Library of Munich, Germany.
  2. Ron Bird & Daniel Choi & Danny Yeung, 2011. "Market Uncertainty and Sentiment, and the Post-Earnings Announcement Drift," Working Paper Series 15, The Paul Woolley Centre for Capital Market Dysfunctionality, University of Technology, Sydney.
  3. Dutt, Tanuj & Humphery-Jenner, Mark, 2013. "Stock return volatility, operating performance and stock returns: International evidence on drivers of the ‘low volatility’ anomaly," Journal of Banking & Finance, Elsevier, vol. 37(3), pages 999-1017.
  4. Kiran Thapa, 2013. "Stock Message Board Recommendations and Share Trading Activity," PhD Thesis, Finance Discipline Group, UTS Business School, University of Technology, Sydney, number 10.

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