Thursday, October 16, 2008

Tongues can move markets

This week, the Prize in Economics was given out by the Nobel Foundation for Paul Krugman’s work that tries to explain international trade. Underlying his theories are the basic assumptions that individuals and firms behave rationally, maximize their utilities, and generally try to approach equilibrium.

But are all those assumptions necessarily true? Behavioral finance and behavioral economics have emerged recently to challenge those fundamental aspects of how markets and economies work. Starting with the fundamental work on cognitive biases by psychologists in the 1970s and 1980s, there is now a growing body of knowledge that provides insights into how human financial and economic behaviors are driven by many biases.

In one recent study, researchers found that company names influence stock performance. Specifically, what the researchers found is that company names that are more fluent to pronounce tend to outperform those that are less so. For example, “fake” company names that were harder to pronounce such as Aegeudux were rated as less profitable by participants in a survey than those with easier names such as “Clearman”. But is this just a survey? Does it extend to real life trading? It does. The researchers looked at IPO performances in the American stock markets in the past 14 years and found that company names and ticker codes (letter codes of stocks used in trading) that were easier to pronounce indeed performed better than those that did not roll off the tongue that easily. The researchers of course tried to statistically control for other potential confounding factors (e.g., company size, etc.). Traditional financial theories would not have predicted something as seemingly irrelevant as company code names would affect stock performance.

What does this say? It doesn’t say that you should now sell your holdings in JSH and start buying more of SIA. It does mean, however, that we need to be aware that markets are not all that rational and are regulated a lot by how we all behave that are not necessarily rational. This may seem like a trivial point, but in times such as these when markets are spiraling out of control, it may be a good reminder.

The writer is a postgraduate student at Harvard University

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