Low Risk and High Return – Affective Attitudes and Stock Market Expectations

Date01 November 2014
Published date01 November 2014
European Financial Management, Vol. 20, No. 5, 2014, 995–1030
doi: 10.1111/eufm.12001
Low Risk and High Return – Affective
Attitudes and Stock Market
Alexander Kempf
Centre for Financial Research (CFR), University of Cologne, Germany
E-mail: kempf@wiso.uni-koeln.de
Christoph Merkle
University of Mannheim, Germany
E-mail: chmerkle@mail.uni-mannheim.de
Alexandra Niessen-Ruenzi
Department of Finance, University of Mannheim, L9, 1-2, 68131 Mannheim, Germany
E-mail: niessen@bwl.uni- mannheim.de
This experimental study investigates the impact of affective attitudes on risk and
return estimates of stocks. Participants rate well-known blue-chip firms on an
affective scale and forecast risk and return of the f irms’ stock.We find that positive
affective attitudes lead to a prediction of high return and low risk, while negative
attitudes lead to a prediction of low return and high risk. This bias increases with
participants’ confidence in their ratings and decreases with financial literacy.
Firm characteristics such as a firm’s marketing expenditures and the strength of
its brand have a positive impact on its affective rating.
Keywords: affective attitudes,risk and return expectations,behavioural finance,
affect heuristic
JEL classification: D80, G02, G11
We thank seminar participants at the FMA 2009 European conference, the IMEBE 2009
conference, the DGF 2009 conference, the University of Mannheim, and the University of
Cologne for valuable comments. We also thank the editor John Doukas and two anonymous
referees for very helpful comments. The authors acknowledge research support from the
Centre for Financial Research at the University of Cologne. All errors are our own.
Correspondence: Alexandra Niessen-Ruenzi.
2013 Blackwell Publishing Ltd
© 2013 John Wiley & Sons Ltd
Alexander Kempf, Christoph Merkle and Alexandra Niessen-Ruenzi
© 2013 John Wiley & Sons Ltd
1. Introduction
Standard finance theory predicts that rational investors trade off a stock’s risk and
expected return leading to a positive correlation of risk and expected return in equilibrium
(Sharpe, 1964). This prediction is based on rational investors who judge risk and return
of a stock solely based on fundamental information in the context of a market model.
However, several empirical papers suggest that individual investors expect a negative
correlation of a stock’s risk and return (Shefrin, 2001; Kaustia et al., 2009; Amromin
and Sharpe, 2005; Weber et al., 2013). In this paper, we investigate whether affective
attitudes towards a firm can explain these biased expectations.
Weadopt a relatively broad definition of the term affect which includes both, emotions
as affective states and attitudes as affective dispositions (cp. Clore and Gasper, 2000).
Affect thus encompasses immediate experiences of feelings and emotions, the associated
channels of mental processing, and the resulting attitudes towards objects.1The opposite
term to affect is cognition, which comprises the reason-based evaluation of situations
and objects. Psychologists and neuroscientists emphasise the outstanding role of affect
in information processing and decision making (Frijda, 1986; Ekman and Davidson,
1994; Damasio, 1994; LeDoux, 1996). They argue that affect influences all stages of
information processing and decision making, partly without conscious awareness of this
In a financial setting, where investors are supposed to evaluate the risk and return
prospects of assets, affective attitudes are likelyto get involved, in particular when assets
represent companies towards which affective attitudes are likely to exist. The way affect
operates in this context can be best described by an affect heuristic, which maintains
that people form a global perception of an object based on their affective attitude
and derive judgments and expectations about this object from this perception (Finucane
et al., 2000, Slovic et al., 2004). A positiveaffective attitude towards a companygenerates
an expectation of high return and low risk for its stock, while a negativeaffective attitude
towards a companyleads to a stock market expectation of low return and high risk. Thus,
in contrast to standard finance theory, the affect heuristic predicts a negative correlation
of risk and expected return. Since risk and return expectations are commonly regarded as
the main determinants of asset allocation decisions, the affect heuristic can thus severely
bias investors’ portfolios.
The main contribution of this paper is to investigate,whether affective attitudes towards
a company have an impact on how a person estimates risk and return of the company’s
stock. Furthermore, we analyse whether the impact of affective attitudes on risk and
return expectations depends on financial literacy of investors and their confidence in
evaluating a firm. Finally, we explore whether the management of a fir m can actively
influence which affective attitudes investors have for this firm.
We analyse the impact of affective attitudes on risk and return estimates in an
experimental setting. Participants in the experiment provide their affective evaluation
of companies on a semantic differential scale (Osgood et al., 1957), a standard tool in
psychology to elicit affectiveattitudes. Participants are further asked to predict future risk
and return of these company’s stock. They also get access to fundamental information
about the companies to prevent that an affective response in the estimation of returns is
merely due to a lack of information.
1In our experimental setting we will mostly refer to ‘affective attitudes towards companies’.
Low Risk and High Return 997
© 2013 John Wiley & Sons Ltd
Our results show that affective attitudes have a strong impact on participants’ risk
and return estimates. Positive ratings lead to an estimation of high expected return and
at the same time low risk. In contrast, negative ratings produce the opposite prediction
of low expected return and high risk. The estimates provided in the experiment clearly
violate the predictions of standard finance theory and suggest the presence of a bias
in expectation formation. The results hold no matter whether the affective ratings are
elicited before or after the risk and return estimation, i.e. we find that an immediate
activation of affective reactions before the risk and return estimations is not necessary
for affect to have an impact on these estimations.
We also find that our results are stronger for participants with lower financial literacy.
This suggests that participants with higher financial literacy are at least partly able
to cognitively correct their affective attitude when confronted with the estimation
task. Furthermore, the results are stronger for participants who indicate that they feel
confident in evaluating the firm. Conf idence thus contributes to a more affectivelydriven
evaluation. Finally, we explore which firm characteristics determine its affective rating
among participants. We find that views on company image, brand and products carry
over to investment expectations. This result supports Fehle et al. (2005), who argue that
firms can use advertising to impact investor behaviour.
There are two important implications arising from our findings. First, our results imply
that investors who are subject to an affect heuristic potentially overweight stocks which
they evaluate positively because they believe these stocks to be more profitable and
less risky than the average investment. At the same time, these investors might ignore
negatively evaluated stocks, which in combination leads to insufficient diversif ication
of their portfolio holdings. Underdiversification of individual investors’ portfolios has
been shown frequently (Grinblatt and Keloharju, 2001; Anderson, 2007; Kumar and
Goetzmann, 2008), and might at least partly be caused by affective attitudes towards
stocks. As firms are rated similarly across participants, our results might also have
an impact on aggregate stock returns. Specifically, the literature on investor sentiment
suggests that stocks with positive affective attitudes should have higher returns in the
short term and then mean revert afterwards (Baker and Wurgler, 2006). Our results
confirm that this might indeed be the case. Second, our results imply that firms with a
positive affective rating might attract a different shareholder clientele than f irms with a
negative affective rating. We show that financially illiterate participants are particularly
prone to the affect heuristic, which is in line with the general finding that especially
individual investors are often subject to behavioural biases (Barberis and Thaler, 2003).
This might have important consequences for firms since a fir m’s shareholder structure
might determine which policies it can adopt (Hartzell and Starks, 2003; Graham and
Kumar, 2006).
Our study builds on the growing literature on the importance of emotions and affective
attitudes for economic decision making (Elster, 1998; Loewenstein, 2000; Loewenstein
et al., 2001) and particularly financial decision making (Goetzmann and Zhu, 2005;
Subrahmanyam, 2008). Forinstance Loewenstein et al. (2001) and Hirshleifer (2001) lay
down a conceptual foundation of the impact of emotions on financial decision making.
Our results empirically support the views expressed in this literature by showing that
affective attitudes play an important role in the estimation of a stock’s risk and return.
Further we extend the literature on the impact of the affect heuristic on information
processing. MacGregor et al. (2000) introduced the affect heuristic into finance and show
that affect is important for evaluating classes of securities, especially when fundamental
information is scarce. Our paper illustrates that affect is important for the evaluation of

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