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Cognitive biases, downside risk shocks, and stock expected returns

Author

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  • 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
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    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

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