| May 12, 2017 | Gabelli School of Business
Baolian Wang says first isn’t always best in stock market
We use rankings every day to help us make decisions—from which restaurant to visit, to which political candidate to choose, to which business school to attend. And studies have shown that the order of choices on a list, even if the ranking is completely random, can have a significant effect on outcomes.
New research by Baolian Wang, assistant professor, shows that this phenomenon can also apply to the stock market. In a new working paper, he explains how the ranking of stocks can affect return volatility, trading volume, and liquidity.
In the first study of its kind in the financial market, Wang conducted a test using data from the Chinese stock exchange, where a group of stocks were ranked based on a rounded daily return that was essentially random.
He compared the performance of stocks appearing in the first and second halves of the list at the end of a day and found those listed in the first half performed better the next day.
“Everyone paid more attention to the first half rather than the second half. If you pay attention to it, you’re more likely to buy it.”
However, Wang discovered that after the second day, stocks that had been in the first half of the list experienced more fluctuation in price. When they no longer drew the extra focus, their initial outperformance reversed.
What effect could this have on the market?
For the Chinese market, “if you understand this, you can form your own trading strategy,” says Wang. You could choose cheaper, less popular stocks because they happen to be at the bottom of the list, knowing they aren’t actually low-performing compared to the ones near the top.
On the flip side, if people pick stocks based solely on where they appear on a list, it lessens the efficiency of the financial market. According to Wang, “if the market’s efficient, two identical firms would have the same price, but here, they’re affected by their ranking.”
In the United States, we don’t use the type of daily return ranking on which Wang’s study is based. However, we do have a “circuit breaker,” which is a temporary stop on trading that occurs when the market drops or rises a significant percentage very quickly. It’s intended to decrease panic by giving people time to think about what’s going on before making their next move.
Based on Wang’s findings, circuit breakers may lead to overreaction, as they could in fact be drawing more attention to stocks that hit the limit before trading is halted. Once the markets reopen, those stocks are at risk of suffering that same volatility and inefficiency.
And when you’re deciding where to invest your hard-earned money, efficiency is at the top of the list.