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06 May 2014

Propensity to Risk and Cultural Inheritance: The January Effect

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We ended our last post with an interesting reflection: if our propensity to risk has cultural, educational and even possibly genetic components, does the evolution of the financial markets (profitability and volatility) also have a cultural component?

This question is far from frivolous. According to Eugene Fama’s efficient market hypothesis, the price reflects all the relevant information on a financial asset. But this information always refers to the institution issuing the stock. In other words: prices always depends on the companies, not on the people who pay them.

And is this so? Let’s look at an example. The January Effect is a widely-studied phenomenon in finance referring to the overall rise in the price of better-quality small caps (small-sized companies) in the first weeks of January.

Why does this phenomenon occur? Here we highlight two of the numerous theories existing, and which are interesting as they come to similar conclusions by means of very different methods.

In October 2009, Quian Sun and Wilson H.S. Tong published a study on this phenomenon (Risk and the January Effect, Journal of Banking and Finance, 2009). Using a complex time-series model they reported that in the early weeks of January there was a rise in the price of these small caps, although there was no sign of any increase in volatility. What does this mean? This increase in profitability is not due to the a higher price demanded by investors in response to a greater risk. They concluded instead that it could be due to the investors’ own perception of the risk. Where investors give greater importance to risk, they look for higher returns. Why investors valued risk more highly precisely in those weeks was still however unexplained.

In contrast to the econometric approach above, Chen et al (Loss Aversion and the January Size Effect, 2011) looked at the problem from the angle of behavioral finance. They studied the different behavior of the equity markets in China, Taiwan and Hong Kong.

What happens at the end of December? Employees receive their annual bonuses. Here we see an interesting effect that had already been noted by the authors of the previous study: according to the theory of relative risk aversion, this sudden rise in families’ wealth brings a higher aversion to risk. In other words, the more you have, the more you value not losing it. What happens (according to the authors) in the first week of January is that private investors invest their bonuses in high-quality financial assets.

In the case of large companies, there is greater market depth and the main shareholders -institutional investors- can sell their positions to private investors without affecting the price. In contrast, in smaller high-quality companies, a sudden increase in demand for shares raises the price. Small poorer-quality companies (or greater risk), on the other hand, do not see any rise in demand.  Thus the cause of the phenomenon is explained.

Is the fact of employees receiving their bonus the reason for the increase in the price of small, better-quality companies in the first weeks of January?  Does the January effect therefore depend on the economic cycle?

The study shows that although the effect is very marked in Taiwan, this is not so much the case in China and Hong Kong. The authors note that in these two last countries there is a higher presence of institutional investors, as opposed to the greater weight of private investors (who are therefore conditioned to an increase in wealth) in Taiwan.

And yet could there be a further explanation? Is there a different cultural inheritance in Taiwan and in Hong Kong and China? Gambling is legal in Hong Kong, but prohibited in Taiwan and China. Does this fact have any influence? Is betting on the financial markets a form of “legal” gambling in Taiwan?

The January effect does not have the same intensity when compared by country, as revealed in this article in the Financial Post. The most significant effect can be seen in Asian countries.  Asian cultures -particularly the Chinese- have a strong gambling tradition. Are these countries more inclined to risk? The January effect would therefore be more acute precisely due to the temporary increase in wealth.

In short, our cultural inheritance -to a degree yet to be established- conditions our perception and attitude to risk, and plays a part in our financial behavior. The educational system can therefore act as a very important management lever, not only from the point of view of teaching, but also through the cultural transmission of values that can bring us closer or distance us from the rest of the world.

Pedro Agudo

Economist, BBVA

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