June 28, 2005

Crystal Clear:
Investors Don't Take Advantage of the Picture

Research by Joshua Pollet, assistant professor of finance, and co-author Stefano Della Vigna, assistant professor of economics at the University of California at Berkeley, was the focus of a New York Times article by Mark Hulbert on June 19.

Hulbert reported on Pollet and Della Vigna's recently released National Bureau of Economic Research (NBER) working paper "Attention, Demographics, and the Stock Market." More than 60 years of data from the Bureau of Labor Statistics from two dozen age-sensitive industries such as toy manufacturers and nursing homes was analyzed. Demand changes from populations are predictable once a specific cohort is born. Even so, few investors look at such predictable events like an increased demand for nursing home care for baby boomers and use that information when making investments.

The authors devised a test of underreaction to information based on demographic variables and looked at whether investors respond appropriately to predictable demographic changes.

"One unusual feature characterizes demographic changes–they are forecastable years in advance. Current cohort sizes, in combination with mortality and fertility tables, generate accurate forecasts of future cohort sizes even at long horizons. Different goods have distinctive age profiles of consumption, and therefore forecastable changes in the age distribution produce forecastable shifts in demand for various goods. These shifts in demand induce predictable changes in profitability for industries that are not perfectly competitive. Consequently, the timing of the stock market reaction to these predictable demand shifts is a test of investor attention to determinants of profitability."

The authors found that demand forecasts predict profitability by industry. But forecasted demand changes over shorter horizons do not predict stock returns. Investors, it appears, are not paying attention to clear and predictable changes over the long term.

The working paper is available online as a PDF document. The New York Times article by Hulbert is available at a fee.