Journal Articles (Peer-Reviewed)
Merkle, Christoph (In press): Financial Loss Aversion Illusion, Review of Finance.
Abstract: Abstract: We test the proposition that investors' ability to cope with financial losses is much better than they expect. In a panel survey of investors from a large bank in the UK, we ask for their subjective ratings of anticipated returns and experienced returns. The time period covered by the panel (2008-2010) is one where investors experienced frequent losses and gains in their portfolios. This period offers a unique setting to evaluate investors' hedonic experiences. We examine how the subjective ratings behave relative to expected portfolio returns and experienced portfolio returns. Loss aversion is strong for anticipated outcomes; investors are twice as sensitive to negative expected returns as to positive expected returns. However, when evaluating experienced returns, the effect diminishes by more than half and is well below commonly found loss aversion coefficients. This suggests that a large part of investors' financial loss aversion results from an affective forecasting error.
Becker, Jochen, Josip Medjedovic and Christoph Merkle (2019): The Effect of CEO Extraversion on Analyst Forecasts: Stereotypes and Similarity Bias, Financial Review, 54 (1): 133-164.
Abstract: In an experiment with professional analysts, we study their reliance on CEO personality information when producing financial forecasts. Drawing on social cognition research, we suggest analysts apply a stereotyping heuristic believing that extraverted CEOs are more successful. The between-subjects results with CEO extraversion as treatment variable confirm that analysts issue more favorable forecasts (earnings per share, long-term earnings growth, and target price) for firms led by extraverted CEOs. Increased forecast uncertainty leads to even stronger stereotyping. Additionally, personality similarity between analysts and CEOs has a large effect on financial forecasts. Analysts issue more positive forecasts for CEOs similar to themselves.
Merkle, Christoph (2018): The Curious Case of Negative Volatility, Journal of Financial Markets, 40: 92-108.
Abstract: In a panel survey of brokerage clients in the United Kingdom, participants mostly perceive their own portfolio as no more volatile than the market portfolio. Taking into account observed portfolio betas, this implies a belief in very low idiosyncratic portfolio volatility, which is even negative for a considerable fraction of the studied investor population. Possible explanations are extreme overconfidence in combination with a misunderstanding of how market and portfolio volatility are related. The identified bias contributes to underdiversification, as a belief in negative idiosyncratic volatility conceals the true benefits of diversification. In an experiment, we confirm the existence of a belief in negative volatility and rule out the underestimation of beta as an alternative explanation.
Merkle, Christoph, Philipp Schreiber and Martin Weber (2017): Framing and Retirement Age: The Gap between Willingness-to-Accept and Willingness-to-Pay, Economic Policy, 32 (92): 757-809.
Abstract: In a large online experiment, we relate the retirement timing decision to the disparity between the willingness-to-accept (WTA) and the willingness-to-pay (WTP). In the WTP treatment, participants indicate the maximum amount of monthly benefits they are willing to give up in order to retire early. In the WTA treatment, the minimum increase of monthly payments in order to delay retirement is elicited. Our results reveal that the framing of the decision problem strongly influences participants' reservation price for early retirement. The willingness-to-accept for early retirement is more than twice as high as the corresponding willingness-to-pay. Using actual values from the German social security system as market prices, we demonstrate that the presentation in a WTA frame can induce early retirement. In this frame, the implicit probability of retiring early increases by 30 percentage points.We further show that the disparity between WTA and WTP is correlated with loss aversion. Repeating the analysis with data from a representative household survey (German SAVE panel), we find similar results.
Merkle, Christoph (2017): Financial overconfidence over time: Foresight, hindsight, and insight of investors, Journal of Banking & Finance, 84: 68-87.
Abstract: Financial overconfidence leads to increased trading activity, higher risk taking, and less diversification. In a panel survey of online brokerage clients in the UK, we ask for stock market and portfolio expectations and derive several overconfidence measures from the responses. Overconfidence is identified in the sample in various forms. By matching survey data with participants’ transactions and portfolio holdings, we find an influence of overplacement on trading activity, of overprecision and overestimation on diversification, and of overprecision and overplacement on risk taking. We explore the evolution of overconfidence over time and identify a role of past success and hindsight on subsequent investor overconfidence in line with learning to be overconfident.
Heuer, Justus, Christoph Merkle and Martin Weber (2017): Fooled by Randomness: Investor Perception of Fund Manager Skill, Review of Finance, 21 (2): 605-635.
Abstract: Return-chasing investors almost exclusively consider top-performing funds for their investment decisions. When drawing conclusions about the managerial skill of these top performers, they tend to neglect fund volatility and the cross-sectional information contained in the number of funds and the distribution of skill. In multiple surveys of sophisticated retail investors, we show that they do not fully understand the role of chance in experimental samples of fund populations. Respondents evaluate each fund in isolation and do not sufficiently account for fund volatility. They confuse risk taking with manager skill and are thus likely to over-allocate capital to lucky past winners.
Merkle, Christoph, Daniel P. Egan and Greg B. Davies (2015): Investor happiness, Journal of Economic Psychology, 49: 167-186.
Abstract: We study investor happiness in a panel survey of brokerage clients at a 5UK6 bank. When investors anticipate future happiness, they set their return aspirations according to personal portfolio risk, objectives, investment horizon, confidence, and other individual characteristics. They are accurate in their forecasts, only rarely are investors unhappy with outcomes they predicted they would be happy with, and vice versa. However, determinants of experienced happiness only partially correspond to the ones found for anticipated happiness. In particular, relative performance plays an important role investors do not anticipate. Having outperformed other people contributes to investor happiness, as does active trading success.
Egan, Daniel P., Christoph Merkle and Martin Weber (2014): Second-order beliefs and the individual investor, Journal of Economic Behavior & Organization, 107, Part B: 652-666.
Abstract: In a panel survey of individual investors, we show that investors’ second-order beliefs—their beliefs about the return expectations of other investors—influence investment decisions. Investors who believe others hold more optimistic stock market expectations allocate more of their own portfolio to stocks even after controlling for their own risk and return expectations. However, second-order beliefs are inaccurate and exhibit several well-known psychological biases. We observe both the tendency of investors to believe that their own opinion is relatively more common among the population (false consensus) and that others who hold divergent beliefs are considered to be biased (bias blind spot).
Kempf, Alexander, Christoph Merkle and Alexandra Niessen-Ruenzi (2014): Low Risk and High Return – Affective Attitudes and Stock Market Expectations, European Financial Management, 20 (5): 995-1030.
Abstract: 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 firms’ 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.
Merkle, Christoph and Martin Weber (2014): Do investors put their money where their mouth is? Stock market expectations and investing behavior, Journal of Banking & Finance, 46 (9): 372-386.
Abstract: To understand how real investors use their beliefs and preferences in investing decisions, we examine a panel survey of self-directed online investors at a UK bank. The survey asks for return expectations, risk expectations, and risk tolerance of these investors in three-month intervals between 2008 and 2010. We combine the survey data with investors’ actual trading data and portfolio holdings. We find that investor beliefs have little predictive power for immediate trading behavior. The exception is a positive effect of increases in return expectation on buying activity. Portfolio risk levels and changes are more systematically related to return and risk expectations. In line with financial theory, risk taking increases with return expectations and decreases with risk expectations. In response to their expectations, investors also adjust the riskiness of assets they trade.
Merkle, Christoph and Martin Weber (2011): True overconfidence: The inability of rational information processing to account for apparent overconfidence, Organizational Behavior and Human Decision Processes, 116 (2): 262-271.
Abstract: The better-than-average effect describes the tendency of people to perceive their skills and virtues as being above average. We derive a new experimental paradigm to distinguish between two possible explanations for the effect, namely rational information processing and overconfidence. Experiment participants evaluate their relative position within the population by stating their complete belief distribution. This approach sidesteps recent methodology concerns associated with previous research. We find that people hold beliefs about their abilities in different domains and tasks which are inconsistent with rational information processing. Both on an aggregated and an individual level, they show considerable overplacement. We conclude that overconfidence is not only apparent overconfidence but rather the consequence of a psychological bias.
Journal Articles (Professional)
Merkle, Christoph (2016): Insights from the Experimental Finance 2016, Credit and Capital Markets, 49 (4): 571-575.
Schneider, Karla and Christoph Merkle (2007): “Minority Report” – Fiction or Reality? Legal Questions raised by Neuroscience with Particular Emphasis on German Criminal Law, Journal of International Biotechnology Law, 4 (6): 227-232.
Merkle, Christoph and Martin Weber (2012): Finanzmarkterwartungen von Privatanlegern - Grundlage für fundiertes Handeln? (within the series "Forschung für die Praxis", Vol. 23).
Merkle, ChristophAhrend, Norbert and Awi Federgruen (2011): Investor Beliefs and Actions: Dissertation, MADOC Publications Server of the Library of the University of Mannheim: Mannheim.
Grohmann, Antonia, Lukas Menkhoff, Christoph Merkle and Renke Schmacker (2018): Earn More Tomorrow: Overconfident income expectations and consumer indebtedness.
Abstract: This paper examines whether biased income expectations due to overconfidence lead to higher levels of debt-taking. In a lab experiment, we exogenously manipulate income expectations of participants by letting income depend on relative performance in hard and easy quiz tasks, thereby exploiting the so called hard-easy gap. Before participants engage in the quiz task, they can purchase goods by borrowing against their future income. We successfully generate biased income expectations and are able to show that participants with higher income expectations initially borrow more. Receiving feedback on their true income, overconfident participants scale back their consumption in following periods. However, at the end of the experiments they remain with higher debt levels.
Merkle, Christoph, Philipp Schreiber and Martin Weber (2018): Inconsistent Retirement Timing.
Abstract: In an online experiment with more than 3,000 participants, we measure time preference consistency and study actual and planned retirement timing decisions. Theory predicts that hyperbolic time preferences can lead to dynamically inconsistent retirement timing. We find that time inconsistent participants retire on average up to 2.2 years earlier than time consistent participants. Participants, who are not yet retired, decrease their planned retirement age as they grow older. This negative effect of age is about twice as strong for time inconsistent participants. The temptation of early retirement seems to rise as participants approach retirement. As a consequence, time inconsistent participants have a higher probability of regretting their retirement decision. In addition, they do not compensate for the loss of social security benefits by buying private pension insurance. Using data from a representative household survey (German SAVE panel), we find similar results.
Merkle, Christoph and Christoph Sextroh (2018): Value and Momentum from Investors' Perspective.
Abstract: We propose a more direct approach to answer the question whether value and momentum are risk factors or anomalies. By asking financial analysts and professionals for their risk perceptions of company stocks, we obtain evidence on what constitutes a risky investment from their point of view. Contrary to the risk factor hypothesis, value and momentum stocks are not regarded as more risky. Supporting the validity of the analysis, other factors such as size and beta fall in line with their traditional interpretation as risk factors. At the same time, we observe higher return expectations for momentum stocks, which is consistent with empirical findings but again inconsistent with analysts believing in a risk-return trade-off.We propose a more direct approach to answer the question whether value and momentum are risk factors or anomalies. By asking financial analysts and professionals for their risk perceptions of company stocks, we obtain evidence on what constitutes a risky investment from their point of view. Contrary to the risk factor hypothesis, value and momentum stocks are not regarded as more risky. Supporting the validity of the analysis, other factors such as size and beta fall in line with their traditional interpretation as risk factors. At the same time, we observe higher return expectations for momentum stocks, which is consistent with empirical findings but again inconsistent with analysts believing in a risk-return trade-off.
Merkle, Christoph, Jan Müller-Dethard and Martin Weber (2018): Closing a Mental Account: The Realization Effect for Gains and Losses SSRN Electronic Journal.
Abstract: How do risk attitudes change after experiencing gains or losses? For the case of losses, Imas (2016) shows that subsequent risk-taking behavior depends on whether these losses have been realized or not. After a realized loss, individuals' risk taking decreases, whereas it increases after an unrealized (paper) loss. He refers to this asymmetry as the realization effect. We replicate this result (N=203) and in addition find a realization effect for the gain domain. Independent of a prior gain or loss, risk taking is higher when outcomes remain unrealized. In several further experiments (N=775), we test theoretical predictions about risk taking and skewness for paper and realized outcomes as well as examine the robustness of the effect with respect to the realization mechanism. In line with the predictions, we find no realization effect for non-positively skewed lotteries and show that the effect is only reliably observed if money is physically transferred.
Germann, Maximilian and Christoph Merkle (2019): Algorithm Aversion in Financial Investing.
Abstract: The tendency of humans to shy away from using algorithms – even when algorithms observably outperform their human counterpart – has been referred to as algorithm aversion. We conduct an experiment to test for algorithm aversion in financial decision making. Participants acting as investors can tie their incentives to either a human fund manager or an investment algorithm. We find no sign of algorithm aversion: Investors care about returns, but do not have strong preferences which intermediary obtains these returns. Contrary to what has been suggested, investors are also not quicker to lose confidence in the algorithm after seeing it err. However, we find that investors are unable to fully separate skill and luck when evaluating either intermediary.