First Impressions: “System 1” Thinking and the Cross-section of Stock Returns | E-Axes
 

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First Impressions: “System 1” Thinking and the Cross-section of Stock Returns

Abstract

For each stock in the U.S. universe in turn, we take the stock?s distribution of past returns, and compute the value that would be assigned to this distribution by (cumulative) prospect theory. We find that this ?prospect theory value? predicts subsequent returns in the cross-section, with a negative sign. This is particularly true for stocks traded primarily by individual investors and for stocks that are hard to arbitrage. We repeat our tests in 46 international markets, and find a similar pattern in a majority of those markets. Our conjecture is that some investors are influenced in their trading by the quick initial impression of a stock that they form after glancing at a chart of the stock?s historical price movements ? a so-called ?system 1? impression that we quantify as the stock?s prospect theory value. Stocks with high prospect theory values make a positive impression on these investors, who tilt toward them, causing them to be overpriced and to earn low subsequent returns.

To download the PDF version of the working paper click here.


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