Nominal Price Illusion: Evidence from Security Analysts' Price Targets
HE Guihua, CUI Chenyu, GAO Hao, QU Yuanyu
School of Accounting, Zhongnan University of Economics and Law; Business School, University of International Business Economics; PBC School of Finance, Tsinghua University; School of Banking and Finance, University of International Business Economics
Summary:
Investors suffering from the nominal price illusion tend to believe that low (high)-price stocks have more (less) upside potential (Birru and Wang 2016). A number of studies have examined the relationship between the nominal price illusion and corporate financial policies and asset prices in China's A-share stock market (He and Chen, 2003; Li et al., 2014; Yu et al., 2014; Xie et al., 2016; Luo et al., 2017). For example, Li et al. (2014) and Yu et al. (2014) find that unsophisticated retail investors are the net buyers after announcements of stock splits and mutual fund shares splits, indicating that retail investors prefer low-priced assets. However, in the above studies, whether investors have biased beliefs about nominal share prices is unobservable, and thus the findings are likely to be contaminated by alternative rational explanations. In China, stocks are traded in lots of 100 shares. Therefore, retail investors with binding budget constraints cannot afford stocks with extremely high prices. Furthermore, retail investors who want highly diversified portfolios will also trade stocks with relatively low nominal prices, because such stocks give them more capital allocation flexibility. In other words, retail investors' revealed preference for low nominal price stocks is very likely to be the result of rational considerations, and not the result of the nominal price illusion. This study uses analysts' price targets to directly test the nominal price illusion hypothesis. It looks at the associations between stock return expectations and nominal share prices. An advantage of our research design is that our setting is unlikely to be affected by the budget constraint. Although budget constraints inevitably impose trading restrictions in investors' portfolio formation, they should not have any real impact on investors' expectations of individual stocks. We find that analysts' future return forecasts for low nominal price stocks are significantly higher than their forecasts for high nominal price stocks, even after controlling fundamental information, beta, and other characteristics of stock returns. Moreover, the above finding is stronger for hard-to-value stocks, as represented by small size, short listing years, high return volatility, low financial reporting transparency, and more intangible assets. We also use stock split events as exogenous shocks to conduct a difference-in-differences (DID) test, and document that analysts' post-split return forecasts become more favorable after a mechanical drop in a nominal share price, which strongly supports our hypothesis. In addition, we conduct several further analysis to confirm that analysts' optimism about low nominal price stocks is the outcome of biased belief, rather than two alternative explanations: (1) that low nominal price stocks could earn higher ex-post future returns than high nominal price stocks; (2) analysts with self-serving motivations strategically release favorable target prices for low nominal price stocks to cater to the preferences of investors. Our paper makes two contributions to the literature. First, by using a large sample of analysts' price target forecasts, we directly identify the impact of the nominal price illusion. Our study documents how and why the nominal price illusion affects investor trading behaviors, corporate financial policies, and market anomalies. Therefore, our study not only confirms previous findings on the nominal price illusion but also provides micro-foundations for the literature (He and Chen, 2003; Li et al., 2014; Yu et al., 2014; Xie et al., 2016; Luo et al., 2017). Second, our study adds to the analyst literature. Previous studies focus on earnings forecasts and stock recommendations, whereas our study examines whether the nominal price illusion biases analysts' price targets. The findings enrich our understandings of how financial analysts are affected by behavioral biases (Hilary and Menzly, 2006; Hribar and McInnis, 2012; Cen et al., 2013; Pouget et al., 2017; Hirshleifer et al., 2019). Our study also has policy implications. As professionals such as financial analysts are still vulnerable to the nominal price illusion, retail investors with limited knowledge and skills should be more aware of this illusion when trading stocks. As retail investors are the main participants in China's A-share market, we also suggest that regulators pay attention to self-dealing corporate behaviors that take advantage of unsophisticated retail investors by means such as initiating stock splits to boost the stock price.
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